SWP739 F E COPY India's Financial System An Overview of Its Principal Structural Features Felipe Morris WORLD BANK STAFF WORKING PAPERS Number 739 FilE COPY I '. I WORLD BANK STAFF WORKING PAPERS f Z Number 739 IWO UJ67 India's Financial System An Overview of Its Principal Structural Features Felipe Morris INTERNATiOAIL 4iOUETA)iY FUiD JOINT LIBRiAEIY [I U G J 1 2 1985 tNTELRIATIONAL DANK roR RXCONSThRUCYION AND DEVELOPMrNT WASE!NGTCN. D.C. 20431 The World Bank Washington, D.C., U.S.A. Copyright (© 1985 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing July 1985 This is a working document published informally by the World Bank. To present the results of research with the least possible delay, the typescript has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. The publication is supplied at a token charge to defray part of the cost of manufacture and distribution. The World Bank does not accept responsibility for the views expressed herein, which are those of the authors and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitation of its boundaries, or national affiliation. The most recent World Bank publications are described in the annual spring and fall lists; the continuing research program is described in the annual Abstracts of Current Studies. The latest edition of each is available free of charge from the Publications Sales Unit, Department T, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from the European Office of the Bank, 66 avenue d'1ena, 75116 Paris, France. Felipe Morris is an economist in the South Asia Programs Department of the World Bank. Library of Congress Cataloging in Publication Data Morris, Felipe, 1953- India's financial system. (World Bank staff working papers ; no. 739) Bibliography: p. 1. Financial institutions--India. 2. Credit control--India. 3. Monetary policy--India. I. Title. II. Series. HG187.I4M67 1985 332'.0954 85-12132 ISBN 0-8213-0564-6 ABSTRACT This paper examines the structure and evolution of the Indian financial system over the past three decades. The study concentrates on the "organized" segment of the system which includes commercial, develop- ment and cooperative banks, the stock market, and various non-banking financial institutions including insurance corporations and mutual funds. The paper also highlights several policy issues in the sector in an attempt to spearhead discussions and further analytical work. The paper first describes the institutional structure of the financial system and then analyzes its evolution and financial interrela- tions using a flow of funds framework and other relevant tools of finan- cial planning. The paper then identifies and analyzes some issues related to credit planning, including credit allocation policies and selected instruments of monetary and credit policy such as interest rates. The analysis of these policies is particularly relevant since credit planning is a important element in India's financial system. The paper provides a broad description and analysis of these policies and indicates areas in which further work may be necessary. ACKNOWLEDGEMENTS Several people provided valuable comments during the preparation of this project. I am particularly grateful to James Q. Harrison, former Senior Economist in the India Division, for his extensive comments on an earlier version of the paper. I also want to acknowledge comments and suggestions from Zafer Ecevit, Roger Grawe, Guillermo Vivado and Ismail Dalla. Of course, none of them is responsible for remainina deficiencies. TABLE OF CONTENTS Page No. INTRODUCTION .. ................................................. vii SUMMARY AND CONCLUSIONS .... .. ............... vii I. INSTITUTIONAL STRUCTURE OF THE INDIAN FINANCIAL SYSTEM I 1 A. Reserve Bank of India . ........ ........ooo 3 B. Commercial Banking ......... . . . . ............... 3 C. Post Office Savings Bank .. Bak.....................o 7 D. Institutional Finance for Industry .....o. 9 E. Agricultural Financing Institutions ...... o.o .....o 16 F. Financial Companies .... .... . ... . o. ..... o o. . ... . 21 G. Stock and Securities Market ... . ........ .. 22 1. Government Securities Market 22.... ...... ... 2 2. Private Capital Market ..oooo .........oo..o.. 23 II. MACROECONOMIC DIMENSIONS OF THE FINANCIAL SYSTEM ....... 26 A. Evolution of the Financial System: Analysis of Various Indicators ...... ........ 26 B. Financial Development Ratios ........... ............ 30 C. Flow of Funds .. ...... . ... ... ... *..... oo....... 32 D. Role of the Financial System in the Mobilization of Savings ....... os....... oo.............................ooo.... 35 E. Inter-country Comparison of Financial System Depth . 41 III. CREDIT ALLOCATION ...o ........ oooo .. .o.. .oo. . . o ..... . 44 A. Comprehensive Picture ..... ............. ooooo 44 B. Deployment of Credit by Scheduled Commercial Banks 44 C. Deployment of Credit by Type of Ownership 51 D. Term-structure of Bank Credit .....ooo.oo.o.o ...... 52 E. Concluding Notes on Credit Deployment ...... o....o. 53 IV. SELECTED INSTRUMENTS OF MONETARY AND CREDIT POLICY 55 Ao Reserve Requirements ..... ... ... .. . .........-... ..... 56 B. Credit Authorization Scheme ........................ 59 Co Interest Rate Policy oo.oo.oo ... 64 1. Introduction o........*..oo....................... oooo... ....... 64 2. Structure of Interest Rates ........ oo ...... 65 3. Commercial Bank Rates ..oo ...... ............. 68 4. Differential Interest Rate Scheme .............. 71 5. Nominal versus Real Interest Rates ............. 71 ABBREVIATIONS AND ACRONYMS ........... . .. . . ........... ........ vi REFEuRvENE.......... 7L - vi - ABBREVIATIONS AND ACRONYMS ARDC - Agricultural Refinance and Development Corporation CAS - Credit Authorization Scheme CCB - Central Cooperative Banks CMIE - Center for Monitoring the Indian Economy CRAFICARD - Committee to Review Arrangements for Agriculture and Rural Development CRR - Cash Reserve Ratio CSO - Central Statistical Organization DRI - Differential Rate of Interest CIC - Ceneral Insurance Corporation ICICI - Industrial Credit and Investment Corporation of India IDBI - Industrial Development Bank of India IFC - International Finance Corporation IFCI - Industrial Finance Corporation of India IRCI - Industrial Reconstruction Corporation of India IRDBI - Industrial Reconstruction and Development Bank of India LIC - Life Insurance Corporation NABARD - National Bank for Agriculture and Rural Development NCDC - National Cooperative Development Corporation NIDC - National Industrial Development Corporation NSC - National Saving Certificate NSIC - National Small Industries Corporation Limited PACS - Primary Agricultural Credit Society PCB - Primary Cooperative Bank PCS - Primary Cooperative Societies PLDB - Primary Land Development Bank POSB - Post Office Savings Bank RBI - Reserve Bank of India RRB - Regional Rural Bank SBI - State Bank of India SCB - State Cooperative Bank SFC - State Finance Corporation SIDC - State Industrial Development Corporation SLDB - State Land Development Bank SLR - Statutory Liquidity Ratio SSIC - State Small Industries Corporation SSIDC - State Small Industries Development Corporation UTI - Unit Trust of India GOVERNMENT OF INDIA FISCAL YEAR April 1 - March 31 - vii - INTRODUCTION 1. The purpose of this study is to provide a descriptive and analytical view of the structure of the Indian financial system with a macroeconomic perspective. The study also highlights the major policy issues in the sector. 2. The study first describes the institutional structure of the financial system and then analyzes its evolution and financial interrelations using a flow of funds framework and other relevant tools of financial planning. This allows the examination of three aspects of the process by which saving is channelled to investors through the financial system: first the amount of savings and investment that go on in the economy, then the question of who saves and who invests, and finally, the flow of funds through financial institutions and markets as money passes on its way from savers to investors. 3. The study then identifies and analyzes issues related to credit planning, including credit allocation policies and selected instruments of monetary and credit policy. The analysis of these policies is particularly relevant since credit planning is an important element in India's Financial System. The purpose of credit planning is twofold: first, to ensure a planned credit expansion for the economy as a whole, and second to make sure that credit flows to desired regions and sectors for increasing production, fulfilling output targets and meeting other national social and economic objectives. Official Government policy with regards to banking is that its operations should be related to development priorities indicated in the national plans as well as to returns on capital. In view of this, the Reserve Bank of India, which coordinates credit planning in the country, makes an extensive use of interest rate and credit allocation policies to provide credit at preferential rates for priority activities, sectors and regions. The study provides a broad description and analysis of these policies and indicates areas in which further work may be necessary. The following tools of credit planning are analyzed: credit authorization scheme, Tandon Committee's inventory and working capital norms, Chore Committee's Report on the Cash Credit System, reserve requirements, differential interest rate scheme and overall interest rate and credit allocation policies. SUMMARY AND CONCLUSIONS Institutional Structure of the Financial System 4. Financial intermediation in India is conducted by a wide range and large number of financial institutions. The Reserve Bank of India is the apex institution of the financial system and the commercial banks have a predominant role since they hold 40% of financial assets. Other important financial institutions are the development finance institutions at the all-India, regional and State level; the insurance corporations; mutual fund institutions such as the Unit Trust of India; and the Post Office Savings Bank. 5. The structure and evolution of the Indian financial system since the late 1960s have been closely related to an increasing degree of public ownership and control of financial institutions. Practically all the important financial institutions are now under public control, and about 85% of total financial assets flow through public sector financial institutions. In addition, the Government regulates and controls capital issues and the functioning of the stock market. This extensive control of the financial system is aimed at ensuring the flow of finance in desired directions and in particular to priority areas of development such as agriculture, small industries and backward areas; and at assisting in the accomplishment of Plan goals. Weaknesses of Financial Institutions 6. The review of the institutional structure of the Indian financial system identified the following major weaknesses: (a) proliferation of financial institutions, (b) low direct mobilization of savings by development finance institutions; (c) low profitability of the commercial banking system, and (d) high level of overdues particularly in agricultural finance institutions. 7. A major weakness of the financial system which should be addressed is the proliferation of financial institutions, some of which overlap in their functions and objectives. This proliferation occurs both in industrial finance and agricultural finance. There is a need to review the role of these institutions, particularly those which are not functioning satisfactorily. A review of functions and objectives may suggest some restructurings and/or mergers which could strengthen the remaining institutions. A careful assessment of financial viability before establishing new institutions or branches of existing institutions would also strengthen the system. 8. Another area which needs closer attention is the scope for larger direct mobilization of savings by development institutions. Most of these institutions do not mobilize any deposits directly from the public, and the bonds and debentures floated by them are only taken up by banks and other financial institutions because of reserve requirements. Consequently, they depend very heavily on the Government, the RBI and the banks for their funds. This sluggish direct resource mobilization is due to the combined effect of regulations and lack of appropriate returns to investors. 9. The low profitability of the commercial banking system is another major concern. Low profitability results from a combination of factors: (a) loan overdues; (b) overstaffing and low efficiency due to outdated procedures and banking technology; (c) high degree of risk absorption and administration costs associated with priority sector lending; and (d) very low capitalization ratios 1/ (1% as compared to 5%-6% for US banks). Due to the predominance of banking in the Indian financial system, efforts should be directed at improving its financial health. 10. High overdues are a problem which affect many Indian financial institutions. It is a widespread problem in agricultural finance but also occurs in industrial credit. Overdues accounted for 44% of total loans outstanding of Primary Agriculture Credit Societies in June 1981 and for 22% of credit outstanding to regional banks as of December 1982. In the case of industrial finance institutions, overdues accounted for 19% of SFCs' outstanding assistance and are also high in SIDCs'. These levels are very high by western standards and seriously affect the ability of some of the institutions to sustain their lending operations. Fund shortages have to be met by direct assistance and borrowing from State and Central Governments. During the past two years, several SFCs have been implementing various measures to improve the recovery position, with encouraging results since overdues fell from 27% in March 1981 to 19% in March 1983. Similar efforts should be undertaken by other institutions, particularly agricultural credit cooperatives and Regional Rural Banks. Evolution of the Financial System 11. Data on the evolution of the financial system since 1950 document the increased "financialization" of the Indian economy and indicate that an increased role of the public sector on the financial system has not retarded its development. This is shown by the ratio of assets of financial institutions to GDP which has increased gradually from 38% in 1950 to 73% in 1975, then quickly to 103% by 1980. Behind this extensive financial deepening has been the increase in the assets of the commercial banks. Other key factors in the growth of the financial system are the emergence of new financial intermediaries such as development banks and the Unit Trust of India, and the expansion of the cooperative movement and of provident funds. 12. Although the growing public sector involvement has not retarded the development of the financial system it may have reduced its efficiency by: (a) reducing the flexibility of the institutions, particularly of commercial banks, to undertake discretionary lending, (b) increasing administrative requirements for processing requests for financial assistance, (c) reducing the scope of the system to allocate resources based on economic and financial considerations rather than on political or social grounds, and (d) reducing the operational autonomy of top management in the larger institutions. Future rapid growth of the system at rates comparable to those achieved in the recent past concurrent with needed improvements in the finances of the institutions is likely to require a relaxation of Government control over certain aspects of the functioning of the system such as the ability of the institutions to engage in discretionary lending and to determine interest rates. 1/ Proportion of total bank assets to total credit allocation. It approximates the inverse of the gearing ratio. Financial Development and Flow of Funds 13. The analysis of the various measures of financial development also shows an increase in the importance of financial institutions in the economy and of financial flows relative to economic activity. This indicates that the financial system is playing an increasingly active role in the transfer of funds from the surplus to the deficit sectors in the economy. The main surplus sectors are Households and Rest of the World (ROW), while the major deficit sectors are the Government and Private Corporate Business. The financial deficit of the Government increased from 1.8% of GDP in 1951-56 to 4.4% in 1961-66 and 6.7% in 1977-81. Similarly, the deficit of the Private Corporate Sector also increased from 0.8% of GDP in 1951-56 to 1.6% in 1961-66 and 1.7% in 1977-81. These two deficit sectors complement their funding requirements by direct borrowing from Households and ROW, and indirectly through financial intermediation. The Household sector, which recorded very high financial surpluses in the 1970s, was the major financier and lent to the deficit sectors and the financial system in the form of currency and deposits, contractual savings, small savings and trade debt. Savings and The Financial System 14. Particularly since the mid-seventies, India has experienced very high savings rates relative to its low per capita income. The acceleration and maintenance of the saving rate at relatively high levels, has been closely linked with income growth--the elasticity of gross domestic savings with respect to real income exceeds 2.0. The increase in the proportion of net disposable income to net domestic product partly explains the rising saving rate, but other factors have contributed as well: (a) the significant financial deepening of the Indian economy since independence, (b) the increasing share of the secondary and tertiary sectors in the NDP which have higher marginal propensities to save; and in the 1970s, (c) the strong growth in production (especially in agriculture), and (d) the improved saving performance of the public sector. 15. Higher saving rates in the Indian economy since the mid-seventies have been accompanied by higher levels of financial savings. Household savings in the form of (a) financial assets and (b) physical assets have increased, with financial savings now accounting for a significant 7.2% of NDP, compared to 0.7% in 1950/51. Among various financial instruments, net deposits have shown the largest increase as a percentage of financial savings of the household sector (see Table 2.8). The bulk of the increase in deposits, and in financial savings, during the 1970s was directed to commercial banks which increased their role in the financial system. Private Capital Market 16. The data on financial savings also underscore the declining importance of shares and debentures to total financial assets of the household sector during the 1970s. The small growth in capital market instruments resulted from the combination of demand and supply factors. On the demand side, investors were not encouraged by the market yields which discounted for risk were less favorable than returns on other financial instruments. On the supply side, companies were reluctant to approach the capital markets due to high costs, and cumbersome procedures and regulations. Resource mobilization through the capital market has improved substantially in the early 1980s in response to measures which have enhanced industrial competitiveness and performance, liberalized debt-equity norms and increased interest rate ceilings for debentures which have made them more interesting to investors. Private corporate capital issues grew from Rs 1.1 billion in 1978/79 to Rs 7.4 billion in 1982/83. Nevertheless, the capital market still accounts for a small proportion of total financial assets. Further work on capital markets is required to provide an insight into likely constraints to future growth and to recommend policy changes to improve their functioning in order to meet the financial requirements of industry more effectively. Credit Allocation 17. The Government intervenes extensively in the credit allocation process both by directing commercial banks to lend to priority sectors and by establishing specialized institutions such as development banks to make priority loans. While the intervention has succeeded in diverting credit into desired channels, its impact in terms of economic growth and efficiency in the use of resources is not very clear. Further work in this area is required. Although there may be a role for policies which encourage credit allocation to previously neglected economic activities, this should not be done at the expense of other equally or more productive activities. A balance has to be maintained between the different sectors, particularly during times of tight credit. Another important change in credit allocation by commercial banks since nationalization has been the increase in the share of credit to the public sector in relation to total credit. Credit outstanding to the public sector increased from 13.4% in December 1972 to 29.5% in June 1977. This highlights the increasing role of the banking system in financing public sector expenditures during the 1970s. Since 1979 there has been a reversal of this trend and in June 1981 the share of the credit outstanding to the public sector stood at 24%. This development is welcome because it releases bank funds for financing private sector investment and consumption. Reserve Requirements 18. The public sector uses a large proportion of banking system resources because, in addition to lending, the banks also invest about 36% of total deposits in Government and Government approved securities. This investment is in line with reserve requirement regulations which require banks to hold 36% of their liabilities in India in Government and Government-approved securities. This reserve requirement, also known as the statutory liquidity ratio (SLR), which stood at 25% of bank liabilities when introduced in 1962 has been raised several times to its present level of 36% and has now become the major channel for directing bank resources to the Government. Scheduled banks are also required to hold 8.5% of bank deposits as balance with the Reserve Bank under cash reserve ratio (CRR) requirements. These high levels of reserve requirements coupled with priority sector lending targets significantly reduce the flexibility of the banking system to engage in discretionary lending. Credit Authorization Scheme 19. Related to credit deployment is the Credit Authorization Scheme (CAS) introduced by the RBI in 1965 as an additional measure of credit regulation. The CAS went through major modifications in 1975, 1979, and 1983 following recommendations of various Committees. The main objectives of the scheme are to enforce financial discipline on the larger borrowers and ensure that they do not preempt scarce bank resources. Under this scheme, commercial and cooperative banks are required to obtain authorization from the RBI prior to extending credit beyond certain limits to large borrowers.l/ The CAS mostly affects working capital requirements although it also affects term lending. In 1975 and 1979, the CAS was modified following the recommendations of the Tandon (1974) and Chore (1979) Committees. The most important recommendations set limits on borrowers for holding inventories and receivables which restrict their ability to borrow from the banking system. These limits, and the CAS in general, have been criticized on various grounds: (a) they do not give the banks the flexibility required to operate in a constantly changing economic environment; (b) they are too restrictive since they try to enforce two types of control: limit inventory holding by firms and restrict the proportion of bank finance in total hence working capital; and (c) they classify industry into only 15 groups, hence they do not make allowance for relevant individual characteristics, including variances in financial strength, market circumstances, management strengths; and the different subsector characteristics. 20. In 1983 the CAS was reviewed by the Marathe Committee which made various recommendations to streamline the authorization process. The Committee recommended that banks should be allowed greater discretion to deploy credit under CAS, in certain specific conditions, even without RBI's prior clearance. The larger discretionary powers are meant to speed up the release of funds to borrowers. The RBI has endorsed the recommendations of the Committee and is moving toward their implementation. A more meaningful liberalization of CAS may not be feasible unless the cash credit system widely used in India is substantially modified (for details refer to paragraph 4.18). A major reason for the establishment of CAS, and for the tightening in its implementation in 1974 and 1979 was to enhance credit control and planning by the RBI on a cash credit system in which this kind of control would otherwise be very difficult. Nonetheless, the fact that it has been subject to so many revisions in recent years clearly indicate that there is some dissatisfaction with the effects of CAS on the ability of Banks to provide timely credit and to be held fully responsible for the allocation of credit. Perhaps other general instruments of credit planning 1/ The scheme has been modified several times in the past to account for changing economic environment. For more details refer to the section on the CAS (paragraphs 4.8 to 4.21). As of June 30, 1983, credit limits under the CAS stood at Rs 170.5 billion and affected 897 parties of which 188 were of the public sector and accounted for 60.9% of the total credit limits. could be modified to replace CAS and achieve its objectives without the associated costs. Interest Rate Policy 21. The level and structure of interest rates in India are fixed by the Government through the Ministry of Finance and the Reserve Bank. The interest rate policy focuses on the following sometimes conflicting objectives: (a) mobilization of financial savings by offering attractive returns; (b) support of activity on particular sectors through lending at preferential interest rates; (c) financing the Government's considerable borrowing requirements as cheaply as possible; and (d) providing a general framework for macroeconomic stability. As a result, the structure of interest rates is too complex and could be simplified in order to raise the efficiency of financial intermediation. Some aspects of interest rate policy such as preferential lending rates for particular sectors and preferential borrowing rates to the Government have the potential for misallocating resources. In the past changes in interest rates have been made on a piecemeal basis and in many cases have caused undesired distortions by providing too high or too low returns to certain types of financial assets. The fact that in addition to a complex interest rate policy, India also has a very detailed credit allocation policy also indicates that there is scope to simplify the interest rate structure without significantly altering the direction of credit. The simplification of the interest rate structure would bring about several benefits to the financial system, including lower administrative costs, improved allocation of resources, and possibly an overall reduction in interest rates. 22. Temporary upsurges in inflation have caused real interest rates to turn negative sporadically, particularly for deposits, but negative real interest rates have not been a significant cause for concern because the phenomenon is temporary and also because the rates turned only slightly negative (excluding 1973-75). The Government has chosen to tackle the problem of negative real interest rates by controlling upsurges in inflation rather than by increasing nominal rates. Therefore, adjustments in the overall level of interest rates have been fairly infrequent over recent years, though there have been a number of changes in interest rates for particular categories of lending. The current policy is sensible since India's inflation is known to fluctuate sharply because it is very sensitive to agricultural performance which in turn is sensitive to fluctuations in rainfall. CHAPTER I INSTITUTIONAL STRUCTURE OF THE INDIAN FINANCIAL SYSTEM 1.1 The Indian financial system is characterized by its two major segments: an "organized" sector, which includes commercial, development and cooperative banks, the stock market, and various non-banking financial institutions including insurance corporations and mutual funds; and a "traditional" sector also known as the informal credit market which provides financing mainly for small enterprises, farms and consumption. The two markets are segregated according to categories of customers, rates of interest and credit conditions, miscellaneous business practices, and to a certain extent, different geographical areas. Systematic information on the size of the informal credit market is not available. For instance, accord- ing to Timberg,l/ the informal credit market accounts for up to 30% of all capital in Indian urban markets while Goldsmith 2/ attributes a much smaller share to its financial operations. This paper will focus only on the organized financial system. 1.2 Financial intermediation in India's "organized" sector is conducted by a wide range and large number of financial institutions which operate largely in the major cities. Since the 1960s, however, there has been a drive toward decentralization which has been quite successful at mobilizing savings, particularly by commercial and cooperative banks in smaller popula- tion centers. The Reserve Bank of India as the main regulator of credit is the apex institution in the financial system. Other important financial institutions are the commercial banks which hold about 40% of the total assets of the financial system. Outside of the commercial banks, the finan- cial system includes institutions which predominantly mobilize resources, such as the Cooperative Banks, the Life Insurance Corporation, the General Insurance Corporation, and the Unit Trust of India and institutions which predominantly provide financing such as industrial, agricultural and housing development bodies at the all-India regional, and State levels. Other important institutions for resource mobilization are the Post Office Savings Bank and Provident Funds which use almost all of their funds to finance government activities. In addition, there are several investment, hire- purchase and leasing companies which have played only a very limited role in the system due to the small development of the capital markets in India. Chart 1 shows the structure of the organized financial system in India. The following is a description of the major institutions in the system. 1/ For an overview of the unorganized capital market refer to "Informal Credit Markets in India," T. Timberg (World Bank, Mimeo, August 1979). 2/ "The Financial Development of India 1860-1977", R.W. Goldsmith, Oxford University Press, 1983. JI_~~~~~~~ II~ L ii M ki ',t ri lI -3- A. RESERVE BANK OF INDIA (RBI) 1.3 The RBI is the central bank of the Indian financial system. It was established in 1935 and from 1949 became a Government-owned institution under the Reserve Bank Act of 1948, which empowers the Central Government to issue directions to the Bank, after consultation with the Governor of the Bank. The RBI formulates and implements monetary and credit policy, func- tions as banker's bank and Central bank; manages the liquidity reserves of the credit institutions and supervises their operations. It also plays an important role in the maintenance of the exchange value of the rupee, exercises control over payments and receipts for international trade transactions, and regulates other transactions in foreign exchange. In addition to these traditional functions of a Central Bank, it undertakes several special functions aimed at developing the financial system such as: integrating the informal credit market into the organized financial sectors, encouraging innovation in cooperative banks and extension of the commercial banking system in the rural areas, and influencing the allocation of long- term investment credit. It also has a creative role in developing the system. For instance, it started the Agricultural and Rural Development Corporation (ARDC), the Unit Trust (UTI), the Industrial Development Bank of India (IDBI), and developed the Agricultural Cooperative Credit System. B. COMMERCIAL BANKING 1.4 Next to the RBI, commercial banks are the most important institu- tions in the system. Commercial banking has changed substantially over the past 30 years due to increasing nationalization and tighter government control over bank operations. In 1955 the Imperial Bank, the largest bank in India, was nationalized and merged with the government-owned banks of some of the princely States to become the State Bank of India (SBI). Other important changes which occurred in the mid-sixties were the implementation of the Credit Authorization Scheme which subjected banks to obtain RBI approval on extension of new credit in excess of Rs 1 million to large companies, and the enactment of the Scheme of Social Control in 1968 which set up guidelines for banks to allocate credit to priority sectors. In July 1969, the 14 largest privately-owned commercial banks were nationalized, bringing under direct government control about 80% of the commercial bank assets. In April 1980, six additional commercial banks were nationalized. The nationalization and tighter government control over the major banks was aimed at reducing the Banks' concentration of economic power and their influence on industrial and business monopolies, and at increasing the flow of credit to small businesses and industries. It was intended that these measures would achieve a wider spread of bank credit, prevent its misuse, direct a large flow of credit to priority sectors and make banks more effec- tive instruments of economic progress. In short, the significant changes in banking were aimed at increasing the role of banks as catalytic agents of development. 1.5 The changes in the banking structure have succeeded in: (a) widening the geographical coverage and spreading banking into rural areas; (b) increasing mobilization of deposits; and (c) reallocating bank credit in favor of people with limited means and in favor of sectors and activities previously neglected. In addition, however, these have resulted in an -4- increasing degree of public ownership and control of financial institutions and consequently has reduced the operational autonomy of their managements. The major government policies aimed at controlling the scope and operations of the commercial banking system is reviewed in Chapters 3 and 4. 1.6 Commercial banking in India is largely of the branch banking type. It consists of scheduled and non-scheduled banks, the former accounting for an overwhelmingly large proportion of total commercial bank assets (99.9%).1/ In June 1982 there were 201 scheduled banks and four non- scheduled banks. The status of scheduled banks confers to them several advantages such as: (a) eligibility for refinance facilities from RBI; and (b) possibility of being granted a license to handle foreign exchange business. Out of the 201 scheduled commercial banks, 121 were regional rural banks, 28 were public sector banks and 52 were private (including 18 foreign banks). Regional rural banks (RRBs) have been set up starting from 1976 under the Regional Rural Bank Act. They are established for the provi- sion of credit to the weaker sections of the rural population, particularly to small and marginal farmers, agricultural workers, artisans, etc. RRBs are authorized to provide short, medium and long-term credit. If they are sponsored by any commercial bank, RRBs can be set up in any State or Union territory with an authorized capital of Rs 10 million and issued capital of Rs 2.5 million, of which 50% is subscribed by the Central Government, 15% by the concerned State government and the balance left to the sponsor bank. In addition, the sponsoring bank aids the RRB by recruiting and training personnel and providing managerial and financial assistance. To ensure their viability, the Reserve Bank of India has granted concessions to the RRBs. For instance, they have direct access to RBI for refinancing assis- tance at 3% below the Bank rate, they are allowed to maintain a lower level of statutory liquidity than the commercial banks and to pay 1/2 per cent more interest on all deposits than commercial banks (except deposits of three years and above). 1.7 There is both support and criticism of Regional Rural Banks. The rationale behind establishing RRBs is that there are rural areas where commercial banks would not like to have their branches because of the high operating cost. However, public sector banks have indicated that many State Governments are not very supportive of setting new RRBs because they fear that they will compete with the cooperative credit institutions. The Committee on Functioning of Public Sector Banks indicated that this fear is unfounded and that there is ample scope for coexistence of cooperative and commercial banks in rural areas.2/ Although some of the RRBs have become viable, others have not and will find this very difficult due to lack of 1/ A scheduled bank is registered in the Bank schedule of the RBI after fulfilling the following conditions: it must (a) have paid-up capital and reserves of at least Rs 500,000; (b) be a limited company in the sense of the Indian Companies Act or founded by special charter or by law; and (c) abide by RBI and central government regulations. 2/ Report of the Committee on Functioning of Public Sector Banks, RBI, 1978. -5- potential in the area or excessive competition from other banks, particularly cooperatives. 1.8 The main problems of RRBs are the high level of overdues and their low profitability. At the end of 1982, the overdues of all RRBs amounted to Rs 1.3 billion or about 22.2 per cent of their total loans outstanding. The position is likely to deteriorate in the near future unless the RRBs take special measures to reduce the overdues such as: (a) upgrading loan appraisal methods; (b) undertaking detailed analysis of their arrears port- folios to identify deliberate defaulters from those with serious problems, and to isolate the cause of the problems; (c) strengthening collection procedures and loan supervision, and (d) drawing up a phased program for reduction of arrears to be closely monitored. Profitability is also a major concern; 39 per cent of the 107 established RRBs incurred losses in 1981. Several RRBs have accumulated losses which exceed the total amount of their paid-up-capital. Low profitability is due to various reasons: (a) high overdues, (b) low spreads between average lending rate and cost of borrowing (this occurs because RRBs' lending is confined to the weaker sections and at low interest rates), (c) inadequate staff resources, and (d) rapid branch expansion without careful assessment of viability or adequacy of infrastruc- ture facilities. 1.9 The important feature to note in Table 1.1 is the overwhelming importance of public sector banks on the total assets, deposits and credits of the commercial banking system. Commercial bank assets totalled Rs 582.2 billion as of December 1980. 90.5% of the assets belong to public sector banks with the State Bank of India and its seven associates jointly holding 31.3% of the total. Private sector banks account for 8.8% of total assets and regional rural banks for the remaining 0.7%. The distribution of deposits and credits between the various types of banks also follow a similar pattern: the share of public sector banks is about 91%, that of private sector banks about 8%, regional rural banks account for 0.9% and non-scheduled banks for 0.1%. -6- Table 1.1: Structure and Scope of Commercial Banking in India (Rs billion) December 1980 /a June 1982 June 1982 Total Total Total # of Banks Bank Offices Assets (Z) Deposits (Z) Credit (Z) I. Scheduled Banks 201 39150 582.1 99.9 428.7 100.0 272.6 100.0 (a) Public Sector Banks 28 29698 526.6 90.5 391.9 91.4 248.9 91.3 1. State Bank of India (SBI) 1 6047 150.2 (25.8) 93.0 72.1 2. Associates of SBI 7 2813 31.8 (5.5) 24.1 14.9 3. 14 banks national- ized in 1969 14 17804 308.4 247.0 146.1 4. 6 banks national- ized in 1980 6 3034 36.2 27.8 15.8 (b) Regional Rural Banks 121 5118 4.1 0.7 2.1 2.5 0.9 (c) Private Sector Banks 52 4334 51.4 8.8 34.7 8.1 21.2 7.8 1. Other Indian scheduled 34 4202 28.8 22.4 12.2 2. Foreign banks 18 132 22.6 12.3 9.0 II. Non Scheduled Banks 4 30 0.1 n.s. 0.1 0.1 Total 205 39180 582.2 100.0 428.8 100.0 272.7 100.0 /a Classification of banks slightly different from that in first and second columns since Assets data breakdown is not available beyond December 1980. Source: RBI, "Report on Trends and Progress of Banking in India 1981-82" and "Statistical Tables Relating to Banks in India." 1.10 The vast increase in the number of banks and the spread of branches into rural areas during the past 15 years, while welcome, have placed severe strains in the organizational, financial and administrative capacity of the banks. Analysis of financial data of scheduled commercial banks shows that the profitability of commercial banks has declined overtime. For example, the ratio of profits before tax to total earnings was 21% in 1956, 23% in 1961, 11% in 1969, averaged 10% in 1975-78 and 9% in 1979-80. Profit before taxes as a percentage of deposits also declined from 1.1% in the early 1960's to 0.9% in the late 1970s.1/ Bank profitability has deteriorated due to the combination of the following factors: (a) higher administrative cost related to lending to priority sectors and opening of branches in rural and 1/ Data taken from RBI, "Statistical Tables relating to Banks in India", various issues. -7- unbanked areas; (b) lower cost recovery associated with credit expansion to priority sectors, particularly to agriculture; (c) interest rate subsidies for various activities such as agricultural credit, small industry, differential rate of interest scheme, and other borrowers at concessional terms; (d) increasing amount of bank funds locked up in "sick industries"; (e) higher cost of funds caused by upward trend in interest rates on deposits and higher proportion of term deposits on total bank deposits; (f) increases in reserve requirements which result in significant amounts of resources deployed in low-yielding assets; and (g) outdated systems and procedures which do not optimize the use of manpower. Table 1.2: Progress of Commercial Banking at a Glance (Outstanding as of June each year in Rs billion) 1969 1972 1975 1979 1982 1983 1984 1. No. of offices 8,262 13,622 18,730 30,202 39,177 42,079 44,583 2. Aggregate Deposits 46.5 76.1 125.5 286.7 461.3 540.4 638.5 (a) Demand 21.1 33.6 52.6 110.5 90.6 102.0 119.4 (b) Time 25.4 42.5 72.9 176.2 370.7 438.4 519.1 3. Aggregate Credit 36.0 54.8 89.6 191.2 301.8 360.1 430.6 % share of priority sector lending 15.0 23.3 27.5 36.6 39.0 39.0 39.2 4. Credit-Deposit Ratio (%) 77.5 72.0 7i.4 66.7 65.4 66.6 67.4 5. Investment-Deposit Ratio (X) 29.3 30.5 32.5 32.7 36.7 37.0 36.3 Source: Report on Trends and Progress of Banking in India, 1983-84; and Banking Statistics, Vol. 8, Dec. 1982; RBI. 1.11 Indian scheduled banks also appear to be somewhat overstaffed. In 1979 they had 520,000 employees, or about 18 per branch; in 1982 the average increased to 20. Consequently salaries and administrative expenses accounted for 22 percent of the total expenses of nationalized banks, while it accounted for only 18% for foreign banks operating in India. C. POST OFFICE SAVINGS BANK (POSB) 1.12 The Post Office Savings Bank, is run by the Post and Telegraph Department on behalf of the Ministry of Finance with the National Savings Organization being responsible for promotional work and publicity. The Postal saving system operates through the network of post offices which allows it to reach remote corners of the country catering to the savings of the lower income population that do not want to venture to commercial banks which they may see as too sophisticated. The Post Office Bank gets a large proportion of its deposits from rural areas: 38% of the deposits and 30% of its resources come from villages. The average size of the post office savings account is about Rs 560 while that for an average bank account is -8- about Rs 940. The POSB accounts for about 17% of total aggregate deposits while banks account for 83%. 1.13 The POSB collects funds through various savings schemes such as: (a) savings bank accounts carrying an interest of 5.5% per annum; (b) recurring and cumulative time deposit schemes; (c) time deposits with 1, 2, 3 and 5 year maturities; (d) Public Provident Funds with 15 years maturity, offering a tax-free interest of 8.5% per annum. Annual deposits vary from Rs 100 to Rs 30,000; (e) National Saving Certificates (NSC) issued at intervals; and (f) Social Security Certificates, introduced in 1982, with 10-year maturity, paying three times the investment at maturity (rate of interest 11.6% per annum) and providing social security benefits. Table 1.3: Breakdown of Outstanding Deposits in POSB (Rs billion) March 1980 March 1981 March 1982 March 1983 Savings Bank 20.07 22.38 23.42 23.95 Cumulative Time Deposits 2.46 3.05 3.64 4.55 Recurring Deposits 3.17 3.77 4.29 5.35 Time Deposits 30.20 35.58 42.45 47.64 Savings Certificates 11.76 14.04 19.75 29.48 Total POSB 67.66 78.82 93.55 110.97 Memo Item Aggregate Bank Deposits /a 396.22 471.1 545.97 637.40 /a Includes POSB and all scheduled banks. Source: Report on Currency and Finance, various issues, RBI. 1.14 These POSB schemes offer higher returns than those of scheduled banks and provide a variety of alternative investment possibilities coupled with tax saving features,l/ thereby attracting higher income groups as well as small savers. A major drawback of the Postal Office Saving system is its inefficiency, related to outdated systems and procedures. This explains why POSB does not account for a larger share of the deposits market even though it offers yields with tax benefits and safety comparable to, or better than, any bank. 1/ Tax concessions vary depending on the savings scheme selected. Some investments provide full shelter from income tax on interest receipts or from wealth-tax, while others offer more limited tax concessions. -9- D. INSTITUTIONAL FINANCE FOR INDUSTRY 1.15 Since independence in 1947, several institutions have been estab- lished by the Government to provide long-term credit. Thus, India has a large number of term financing institutions, which were set up to promote and provide long-term finance to viable investment projects in industry and agriculture. Some of these institutions operate on a national basis (all- India institutions) while others operate within regions or States. 1.16 The all-India institutions, under the direction of the Central Government, specialize in lending to medium and large industries, with some also providing refinance and indirect assistance to other financial institu- tions and smaller industrial units. The regional and state institutions controlled by State Governments concentrate on small and medium industrial units. These financial institutions obtain their resources partly from the Government and partly as loans or refinancing from the capital market. The assistance provided by these institutions is quantitatively important in the financing of corporate investment. All these development finance institu- tions not only provide term loans but also provide equity capital and are, therefore, shareholders in many enterprises. This enhances the role of the institutions in providing support to industrial units in the areas of management and finance. 1.17 The principal all-India industrial finance institutions are the Industrial Development Bank of India (IDBI), the Industrial Credit and Investment Corporation of India (ICICI), Industrial Finance Corporation of India (IFCI), Life Insurance Corporation of India, and Unit Trust of India (UTI). At the regional or State level, the most important institutions are the State Financial Corporations (SFCs), which finance small and medium scale industries and the State Industrial Development Corporations (SIDCs) which mainly promote and help finance larger industries having direct State shareholding. Other institutions at the State level, which also provide financial assistance, are State Small Industries Corporations (SSICs) which allocate and distribute raw materials to small industries and provide some hire-purchase finance, and State Small Industries Development Corporations (SSIDCs) whose main activities are to establish and manage industrial estates. Table 1.4 shows the major financial institutions providing funds to industry. 1.18 An important feature of the system for industrial finance in India is the participation of major investment institutions in consortium financ- ing with other all-India financial institutions. The Unit Trust of India (UTI), Life Insurance Corporation of India (LIC), and General Insurance Corporation (GIC), work closely with other all-India financial institutions to meet the financial requirements of the industrial sector. In order to facilitate the application process for financial assistance, the modalities of the consortium finance have been streamlined. The institutions have introduced common application forms, the "lead" institution concept and the Project Financing Participation Scheme. Proposals for project assistance are now submitted in a common application form to one of the institutions which forwards copies to the other institutions. The "lead institution" -10- appraises the project in association with the other participating institu- tions and sanctions assistance after the sharing of assistance is decided in inter-institutional meetings. 1.19 The following sections discuss the functioning of the major institu- tions providing finance for industry, looking at: (a) the structure of their capital and ownership, (b) their rationale and major activities, and (c) their outstanding features. Table 1.4: Institutional Finance for Industry (Rs Billion) Financial Assistance 1981/82 Total Institution Abbr. Sanctioned % Disbursed Assets (1982) (Rs billion) Industrial Development Bank of India IDBI 13.3 /a 37.2 10.4 43.31 Industrial Finance Corporation of India IFCI 2.4 6.7 2.0 7.54 State Financial Corporations (18) SFCs 5.9 16.5 4.0 14.23 Industrial Credit and Investment Corporation ICICI 4.1 11.5 2.8 10.37 Industrial Reconstruction Corporation of India IRCI 0.6 1.7 0.4 National and State Industrial NIDC Development Corporations (26) SIDC 3.0 8.4 2.1 Life Insurance Corporation LIC 1.4 3.9 0.9 70.91 /b Unit Trust of India UTI 1.3 3.6 0.7 4.95 /b General Insurance Corporation GIC 0.9 2.5 0.5 Export Import Bank of India EXIM 2.9 8.0 2.1 2.6 Total 35.8 100.0 25.9 /a Excludes refinance to SFCs and SIDCs. Tr In 1980. Source: Report on Currency and Finance, RBI. All-India Financial Institutions 1.20 Industrial Development Bank of India (IDBI) - IDBI has been respon- sible for coordinating term finance institutions for industry since 1964. The IDBI was established in response to the perceived need for an apex institution which would coordinate the operations of the industrial finance institutions which, although quite large in number and diversity, did not adequately meet the requirements of medium and long-term finance nor of rendering promotional services to the industry. Founded as a subsidiary of the RBI, it holds an interest of 50% in the Industrial Finance Corporation of India (IFCI). It is the largest development bank in India and formal coordinator of other term-financing institutions. It provides financing to SFCs and SIDCs through refinance and bills discounting facilities and equity participation and refinances commercial banks. It also finances industry directly and provides technical and administrative assistance through estab- lishment of and support to Technical Consultancy Organizations (TCOs). 1.21 During the last five years there has been a marked shift in the composition of assistance in favor of small and medium enterprises under IDBI's indirect schemes (refinance of industrial loans and rediscounting of bills for sale of indigenous machinery on defined basis). Direct assistance which formed 37% of total assistance in 1978/79 gradually declined to 27% in 1982/83. This shift was allowed by improved conditions in the capital markets and greater participation by GIC and UTI in consortium financing. In 1982/83 assistance sanctioned by IDBI was distributed as follows: direct project finance (22%), underwriting and direct subscriptions (1.6%), refinance of industrial loans (49%), rediscounting of bills (21%), soft loans (1.7%), subscription to shares and loan of financial institutions (2.6%), and others (2.1%). 1.22 In 1982/83, IDBI's total fund requirements for disbursement of assistance, repayment of borrowings, and interest and dividend payments amounted to RS 18.8 billion. Internal generation of funds met 47.1% of the requirement, and the balance was covered by market borrowings (27.8%), borrowings from RBI (16.5%), increased COI share capital (1.6%), and others (7%). 1.23 The Industrial Credit and Investment Corporation of India (ICICI) was founded in 1955 and is owned and financed mainly by the private sector. Participation in its capital are from commercial banks, insurance companies, local limited companies, private persons, and various foreign insurance and limited companies. It promotes private enterprises in three ways; firstly, it offers medium- and long-term loans, share and debenture underwriting, equity participation, loan guarantees and provision of managerial and tech- nical assistance to enterprises; secondly, it lends heavily to non- traditional sub-sectors such as chemicals and petrochemicals, electrical equipment and electronics and mechanical engineering, and thirdly, it provides the most important institutional source of foreign exchange financ- ing for private industry, accounting for over three-fourths of foreign exchange financing by all of the institutions. There are no firm limits on the size of an enterprise ICICI is prepared to assist, nor is there a maxi- mum or minimum limit on the investment it will make. In addition, to industrial finance, ICICI also lends for rural development projects. -12- 1.24 ICICI has the strongest financial position of all the institutions providing industrial finance. In 1982/83 internal generation of funds met 44.2% of requirements, the balance being provided by market borrowings (53.6%) and borrowings from GOI/RBI/IDBI (2.2%). Overdues as a percentage of aggregate outstanding assistance were 2.6Z, the lowest of all the institutions in the consortium (compared with 4.8% for IDBI, 4.3% for IFCI and 19.1% for SFCs). 1.25 Industrial Finance Corporation of India (IFCI), was founded in 1948, with its ownership held jointly by public and private sector institutions. Participating in its capital are the IDBI (50%), scheduled banks, cooperatives, other banks, insurance companies, investment trusts, etc. It lends and invests only in limited private and public sector companies or cooperatives engaged in manufacturing, shipping, mining, hotels and power. IFCI's assistance is available for setting up new industrial projects and also for the expansion, diversification or modernization of existing ones. Assistance may take the form of long-term loans, underwriting and subscrib- ing to equity, preference and debentures issues, and guarantees. In 1982/83, IFCI financed 46% of its fund requirements from internal generation, 11% from GOI/IDBI lending and 43% from other market borrowing. 1.26 The Industrial Reconstruction Corporation of India (IRCI) was founded in 1971 originally to provide financial and technical assistance for reconstruction and rehabilitation of sick industrial enterprises in West Bengal; however, in recent years, it has expanded its operations beyond West Bengal. IDBI holds 50% of its capital, the balance being provided by IFC, ICICI, the State Bank, the nationalized banks and the Life Insurance Corporation of India. 1.27 IRCI was the only organization dealing mainly with "sick" industrial units, but did not have the power to bring about structural changes either in the management or finances of the assisted units. In 1982/83 internal generation of funds contributed to 12.6% of IRCI's fund requirements, bond issued raised 12.5%, and the balance was met by borrowings, subsidies, and incentives from Government. In July 1984, a new bank was formed, the Industrial Reconstruction and Development Bank of India (IRDBI), which will take over the operations of IRCI. IRDBI will be an independent organization like IDBI and will have power to revive, liquidate, sell and order mergers of industrial units assisted by it. In order to avoid the financial problems of IRCI (low internal generation of funds and very high level of overdues), IRDBI will embrace a wider spectrum of industries. 1.28 Export-Import Bank of India (EXIM BANK) was established in 1982 to strengthen the institutional framework for encouraging the export of non- traditional products. It finances, facilitates, and promotes foreign trade of India and coordinates the work of institutions engaged in financing exports and imports. EXIM BANK started its operations with an authorized capital of Rs 2 billion, which can be increased to Rs 5 billion. As on December 31, 1983, its resources comprised paid-up capital of Rs 1 billion, long-term loans of Rs 450 million from GOI and Rs 1,250 million from the RBI, and Rs 1,522.76 million due to IDBI on transfer of export loans. In 1983, the Bank also raised Rs 530 million in the domestic bond market and -13- two Euro-dollar loans aggregating US$50 million. During 1983 the Bank's commitments aggregated Rs 3,138 million. Investment Companies Providing Industrial Finance 1.29 The Life Insurance Corporation of India (LIC) was founded in 1956 by the nationalization and merger of about 250 independent life insurance societies. Its main purpose is to carry on life insurance business, but has gradually developed into a specialized all-India financial institution. It plays an important role in the capital market of the country and is one of the two largest and most successful institutional investors in India. By law, it must invest 25% of its funds in Government securities and a further 25% in "approved" securities. It also invests in infrastructural facilities, housing and industry. LIC is the most important institution underwriting equity and debenture issues for the industrial sector. 1.30 Apart from underwriting and purchasing corporate securities, LIC finances private industry through subscriptions to the shares and bonds of industrial financial institutions and also provides finance to corporate enterprises in the form of direct loans. A notable feature of LIC's long- term assistance to industry has been its rising share of loan assistance as against underwriting and direct subscription. In 1981/82, 76.5% of LIC's total assistance to industry was in the form of loans, while the remaining 23.5 was in subscriptions. However, although LIC direct financing to industry has grown considerably, loans sanctioned by LIC constitute only about 1% of total private corporate capital formation. 1.31 The General Insurance Corporation (GIC) was formed when the manage- ment of general insurance businesses in India was taken over by the Government in 1971 and subsequently nationalized in 1973. According to Government guidelines, 70% of annual additions to investible funds have to be invested in "socially-oriented" sectors. Such investments include Central and State Government securities, bonds and debentures of public sector undertakings and also loans on soft terms to State Governments and other agencies engaged in housing and urban development. Total investments of the GIC stood at Rs 12.8 billion in 1982. About one-half was invested in Government and other approved securities, one-third in shares and debentures, term loans and deposits with companies, and the balance in loans to banks on participation certificates and bills rediscounting schemes. 1.32 Unit Trust of India (UTI), was founded in 1964 and in 1976 became an associate institution of IDBI. It is the largest mutual fund in India. Initial ownership was split as follows: RBI 50%, LIC 15%, State Bank of India 15%, and other banks and financial institutions 20%. Beyond the initial capital, UTI raises funds by the sale of small denominations (units). The yield from these units, which is market-based, is tax free up to Rs 5000. UTI encourages savings by middle and low-income groups, and channels these funds to industrial development. It thus enables small savers to invest in industry without exposing their savings to undue risk. The UTI is a major underwriter of public shares and debenture issues, and has emerged as an important institutional holder of corporate securities in the industrial securities market vis-a-vis the other financial institutions. -14- The establishment of the UTI has enlarged the market for industrial securities. 1.33 UTI's investible funds reached Rs 8.7 billion at the end of 1982/83, of which 81.3% were placed in the industrial corporate sector. In 1982/83, UTI provided Rs 1.3 billion in direct assistance to the corporate sector, 55% in the form of privately placed debentures and the balance in the form of underwriting, direct subscriptions, firm allotments and rights issues. State Level Industrial Finance Corporations 1.34 State Financial Corporations (SFCs), have been established in capital cities of 18 federal states; most of them as a result of the State Financial Corporation Act of 1951. Their shareholders are the respective federal State governments, the IDBI, credit cooperatives, insurance companies, investment trusts and private shareholders. Private ownership cannot exceed 25% of SFCs total capital. SFCs obtain additional capital by taking deposits from the public, borrowing from State governments and the RBI, and refinancing loans with IDBI. External resources accounted for 66% of total funds required in 1982/83, 63% of which was provided by IDBI through refinancing and 26% were borrowed from GOI and RBI. The assistance of SFCs to industrial units is mainly through: (a) offering loans for acquisition of fixed assets; (b) guaranteeing for loans received by industrial undertakings from scheduled banks or State Cooperative Banks; (c) guaranteeing deferred payments dues from any industrial concern in connection with purchase of capital goods; and (d) underwriting the issues of stocks, shares, bonds or debentures of industrial units. 1.35 A disquieting feature of SFCs' operations has been the growing level of overdues. Total overdues, which were Rs 0. 92 billion in March 1977 and Rs 1.75 billion in March 1979, have increased to Rs 2.25 billion in March 1981, and Rs 2.67 billion in March 1982. By comparison disbursement of assistance in 1981/82 was Rs 3.15 billion. Overdues therefore constitute 19% of total loans outstanding. The recovery performance varies widely among the SFCs. During the past two years, several SFCs have been implementing measures to improve the recovery position, with encouraging results. As a result, the share of overdues to total loans outstanding declined from 27% in March 1981 to 23% in March 1982 and 19% in March 1983. 1.36 The persistence of major problems in most SFCs calls for remedial action. The following are some areas of SFCs' operations which should be addressed: (a) high turnover of staff at management levels: (b) inability to attract and retain experienced professional staff; (c) inadequate manage- ment information systems; (d) major deficiencies in appraisal procedures; (e) weak supervision and collection procedures, and (f) high growth in operations not supported by adequate organizational structures to appraise -15- and supervise operations and provide appropriate technical assistance to borrowers .l/ 1.37 The Industrial Development Corporations, which exist both at the federal level (NIDC) and at the State level (SIDC) are not exclusively financial institutions. Their original aim was to promote those industries necessary to fill gaps in the industrial infrastructure. To achieve this, the institutions were provided with financial resources and technical and commercial know-how. Unfortunately, the NIDC has not lived up to expecta- tions and has remained as an agency of the Ministry of Industrial Development, merely undertaking investigations of publicly-owned industrial projects. The SIDCs, on the contrary, have recorded sustained growth in their operations. The main activities carried out by SIDCs are: (a) granting financial assistance to medium-scale industrial units in the form of loans, guarantees and underwriting or directly subscribing to shares and debentures; (b) promoting industrial development through preparing techno- economic surveys and feasibility studies, identifying projects, and select- ing and training entrepeneurs; (c) administering various State Government incentive schemes; (d) developing industrial areas, constructing sheds and providing infrastructural facilities; and (e) promoting joint sector projects in association with private promoters. Because of this record, IDBI has extended refinance assistance to SIDCs since 1976, and at present 25 SDICs are eligible for refinance assistance. External sources accounted for 65% of total fund requirements in 1982/83 and IDBI provided 49% of external funds mobilized. The aggregate sanctions of SIDCs recorded an almost three-fold increase from Rs 0.98 billion in 1978/79 to Rs 2.97 billion in 1982/83. 1.38 As in the case of SFCs, the arrears position and poor recovery performance are major concerns. Total outstanding arrears at the end of 1982/83 was Rs 648 million, 34% higher than the year before. There were wide variations in the recovery rates of SIDCs, with Gujarat achieving 71% while Assam only achieved 6.2%. Ten SIDCs had recovery rates which ranged between 40% and 50%. 1.39 The National Small Industries Corporation Limited (NSIC), a government-funded institution, established in 1955, promotes the development of small industrial units.2/ It only extends financial assistance through its hire-purchase operations. It provides services such as: (a) securing contracts from the Central Government Stores Purchasing agencies; (b) exporting products of small industries; (c) training industrial workers and supervisors in its Prototype Development and Training Centers; (d) constructing and managing industrial estates; (e) supplying imported 1/ For more details on SFC's operations and problems refer to "Project Performance Audit Report. First IDBI/SFC Project", World Bank June 1984 (Unpublished internal document). 2/ Defined as small business (up to 50 workers) which use electricity, and larger businesses (up to 100 employees) which do not use electricity and have a capital of less than Rs 750,000. -16- and indigenous machinery and equipment on easy installments under its hire- purchase scheme; (f) distributing scarce raw materials and other components at comparatively less expensive rates than suppliers' credits; and (g) refinancing various schemes of the State Small Industries Development Corporations (SSIDCs). Besides its headquarters in Delhi, it has regional offices in Bombay, Madras and Calcutta and sub-offices in other major cities. The NSIC is wholly owned by the Union Government. It supplements its financial resources through borrowings and grants from the GOI, and by foreign credits and loans from banking institutions. Although NSIC does make a significant contribution to the promotion of small industry, its role as financier is rather small because of inadequate financing and low replicability of its hire-purchase operations due to inadequate project appraisal and low recovery of principal and interest. 1.40 The development finance institutions occupy an important place in industrial planning and promotion. The seven all-India institutions 1/ together account for about three-fourths of the assistance sanctioned by all term financial institutions, including SFCs and SIDCs. The State level institutions (SFCs and SIDCs) also occupy an important role in industrial promotion but are much weaker institutions in terms of human, financial and administrative resources. In order to strengthen these institutions, state Governments should study the possibility of restructuring them to reduce duplication of activities and to improve their administration and finances. E. AGRICULTURAL FINANCING INSTITUTIONS 1.41 A thorough review of agricultural finance will not be attempted here due to the diversity of institutions and complexity of the system. Thus, only a brief description of the system and of its major institutions will be made to indicate the linkages with the rest of the financial system. Chart 2 shows the complexity of the existing institutional set up for rural finance. In addition, this section will analyze major issues in agricul- tural finance. 1.42 India has followed the "multi-agency" approach in providing rural finance. Under this approach, cooperative, commercial, regional banks and other field level institutions provide rural finance and are supported by Central and State Governments and national level institutions such as the Reserve Bank of India, the National Bank for Agriculture and Rural Development, the National Cooperative Development Corporation and the Industrial Development Bank of India. The field level institutions which provide credit to individual borrowers are: (a) primary agricultural cooperative credit societies providing both short-term and medium-term credit to their members; (b) primary cooperative land development banks or branches of State cooperative land development banks providing long-term credit to their members; (c) branches of commercial banks, and (d) branches of Regional Rural Banks (RRBs). Of the total agricultural credit outstand- ing at the end of June 1980, cooperatives accounted for 59.4%, commercial banks for 38.8% and RRBs for 1.8%. 1/ IDBI, ICICI, IFCI, IRCI, LIC, UTI, and GIC. CHART 2 AGRICULTURAL RNANCE state d Deveo_nt (coop wteflhm) (Coop insfttAlcns) nk(C)BksFM j DCCO ICCP (coop insMvor)g I I I I I iS NCDC~~~~~~~ I I (PAC) Soite PAa [lSl DO Fcwr & I LII IJE Z E ZI~PLM twlb bwvImji ,mu, Leg.l 9ttbc Bav l- ?&aW Short-Tean CmM L _ . Sr- OeD -18- National Bank for Agricultural and Rural Development (NABARD) 1.43 NABARD is the apex institution in the field of credit for agricul- ture and other rural economic activities such as small-scale industries, cottage and village industries, handicrafts and other crafts. It was set up in 1982 to coordinate agricultural credit and provide loans and refinance assistance to the financial institutions operating in the sector. It has taken over the entire undertaking of the former Agricultural Refinance and Development Corporation (ARDC) as well as the Reserve Bank's functions in the sphere of coordination and refinancing of rural credit. NABARD will provide the same refinance facilities which were available from ARDC to commercial banks, RRBs, State Land Development Banks (SLDBs) and State Cooperative Banks (SCBs). In addition, the refinance assistance previously given by the Reserve Bank will be provided to RRBs and SCBs. Thus, it is empowered to provide short, medium, and long-term assistance. 1.44 In addition to its role as refinancing agency in the sector, it also: (a) provides institution building facilities; (b) coordinates the rural financing activities of all the institutions involved; (c) monitors and evaluates agricultural development projects it has refinanced and (d) invests in share capital or securities of institutions concerned with agriculture and rural development. The National Cooperative Development Corporation (NCDC) 1.45 NCDC was established in 1962 to promote and finance projects and programs carried out by agricultural and agro-industrial Cooperative Societies. NCDC is authorized to advance loans, provide grants and subsidies, and participate in the share capital of cooperative enterprises with inter-State activities. NCDC has promoted projects involving grain storage, sugar factories, oil extraction, ginneries, spinning mills, dis- tribution of fertilizer, etc., marketing of agricultural produce and trade of consumer goods in rural areas. Its role is not limited to that of an investment financing institution, but includes technical and managerial support to the subproject investors during the course of subproject implementation and in the operational phase. NCDC has, over the years, acquired considerable experience in the implementation of agro-processing projects on the technical as well as managerial level. 1.46 In contrast to NABARD's sole responsibility at the national level for refinancing agricultural credit to cooperative and commercial banks, NCDC specializes in project lending. NCDC lends through some of the same financial intermediaries which NABARD refinances (SCBs and SLDBs), but its loans are used for investments by Cooperative Societies and not individual farmers, and the number of subloans is much smaller than NABARD's. NCDC's funds consist of grants and loans from GOI, retained earnings, and borrow- ings from the market. Unlike NABARD, it is not entitled to refinance its loans through the Reserve Bank. Cooperative Credit System 1.47 The cooperative credit system provides short, medium and long-term financing. The cooperative credit structure for short- and medium-term -19- credit is a three-tier federal structure with a State Cooperative Bank (SCB) at the apex level in each State, the Central Cooperative Bank (CCB) at the district level in each State and the Primary Cooperative Societies (PCS) and Primary Agricultural Credit Societies (PACS) at the base. State Land Development Banks (SLDBs) are the apex cooperative institutions engaged in long-term lending for agriculture. Together with commercial banks they are the only sources of formal long-term credit to individual farmers. SLDBs function through branches or affiliated Primary Land Development Banks (PLDBs) providing development loans for periods up to 15 years, mostly refinanced by NABARD. 1.48 The financial performance of the various types of cooperatives varies significantly. While SCBs ad SLDBs are generally profitable and have low overdues, the Primary Cooperatives and Credit Societies show weak finances and large overdues. Furthermore, while the State and Central cooperative banks have been able to mobilize deposits to contribute a large proportion of their working funds, the Primary Agricultural Credit Societies have failed in promoting and mobilizing savings from their members. Deposits in SCBs make up for about 60% of their working capital and own funds finance 12%. The CCB's own funds constitute 16% of working capital and deposits make up about 50%. In contrast, the PACS depend on borrowings from other financing agencies to fund about 74% of their working capital. The PACS are plagued with financial difficulties of which the most important is the high percentage of overdues to loans outstanding, which stood at about 44% as of June 1981. Table 1.5 provides some major indicators of the performance of the cooperative movement in India. Issues in Agricultural Finance 1.49 The main issues in agricultural finance are (a) poor loan recovery and high overdues; (b) high cost of agricultural credit; and (c) prolifera- tion of institutions. These problems will only be solved by undertaking a rehabilitation program which includes (a) restructuring of institutions; (b) upgrading and strengthening field level staff; (c) improving managerial and supervising capacity; and (d) reducing political interference in loan recovery efforts. 1.50 During the 1970s, the volume of short, medium, and long-term institutional credit disbursed to farmers grew substantially, practically tripling in nominal terms and increasing annually by 4.5% in real terms. However, the ability of the rural credit administration to handle this expansion, while maintaining adequate quality control, has grown much more slowly. Overstrained managerial capacity, inadequate and poorly trained field level staff and lack of effective procedures for supervision, monitor- ing and evaluation of credit disbursements have resulted in extremely poor loan recovery and high overdues. Political interference by state govern- ments in loan recovery efforts have exacerbated this problem. Overdues have been particularly high for long-term credit, hovering around 50% for the last several years. Both commercial and cooperative banks are affected, but the latter have suffered more acutely since their loan portfolios have been concentrated on agricultural lending, particularly for private wells. Many cooperatives have been forced to restrict lending and sizeable state govern- ment subsidies are needed to keep them solvent. The impact of these -20- constraints is evident in the virtual stagnation in the growth of real credit since the start of the Sixth Plan. The need to begin what will be a slow process of rehabilitation is urgent. It is essential that steps be taken to upgrade and strengthen field level staff while improving coordina- tion between credit institutions and other agencies related to credit operations. 1.51 According to the 1981 Report of the Committee to Review Arrange- ments for Institutional Credit for Agriculture and Rural Development (CRAFICARD), the principal reasons for overdues are: (a) failure to tie up lending with productive investments; (b) neglect of/or absence of efforts for marketing arrangements and linkage of credit recovery with sale of produce; (c) defective loan policies, including untimely loan disbursements, underfinancing/over-financing and unrealistic scheduling of loan repayment; (d) misapplication of loans; (e) ineffective supervision; (f) apathy and indifference of management to take coercive measures for recovery; and (g) lack of responsibility and sense of discipline of borrowers.l/ A primary cause, however, of persistently high levels of overdues has been the rapid expansion of lending in response to pressures to achieve mandated credit distribution targets. Table 1.5: Progress of Cooperative Credit Movement in India (1982/83 figures in Rs billion) SCBs CCBs S/CLDBs PACS PCBs Number (in Units) 28 340 19 94,000 1,281 Owned Funds 4.73 8.25 3.52 8.80 3.93 Deposits 21.17 31.84 n.a. 3.81 22.78 Working Capital 38.95 62.41 28.45 n.a. n.a. Loans Issued 41.90 45.08 4.26 /a 22.91 n.a. Loans Outstanding 29.06 43.05 20.47 7a 31.08 18.08 Loans Overdue 1.83 13.30 2.85 7r 13.09 n.a. /a Long-term loans 7T Includes interest overdue n.a. - not available Source: National bank for Agriculture and Rural Development (NABARD) and Reserve Bank of India. 1/ A 1974 RBI study on Overdues of Cooperative Credit Institutions reached similar conclusions. -21- 1.52 Another issue in agricultural finance is the current inadequate spread between the costs of agricultural lending and the revenues from these operations. Financial intermediaries face very high administrative costs while lending to a multitude of small beneficiaries which are not covered by appropriate rate spreads. Agricultural lenders have to rely on Government subsidies or cross-subsidize their agricultural credit operations from other profitable activities. Since interest rates are regulated by the Government, this problem will only be resolved by a thorough revision of the structure of interest rates, particularly of those rates which affect agricultural lending. 1.53 Another weakness of the agricultural credit system which has to be addressed is the proliferation of institutions, many of which are finan- cially not viable, and which overlap in their functions and objectives. A restructuring of the agricultural cooperative credit system would be beneficial. In addition further establishment of new institutions should only be authorized after careful consideration of financial viability. F. FINANCE COMPANIES 1.54 The private sector as well as the Government raise funds on the stock market. As in other countries, India's financial system also has non-banking financial intermediaries which compete with banks in the mobi- lization of deposits and in credit allocation. So far these companies have not played an important role in influencing the direction of savings and investment or in mobilizing financial flows. The major types of financial companies are: hire-purchase finance companies, leasing companies, invest- ment companies, housing finance companies, loan companies or finance corporations, and mutual benefit financial companies. They are mainly engaged in financing industry by advancing loans, in financing hire-purchase operations, providing leasing facilities, trading in shares and securities and investing in securities in general. Some also function as merchant bankers (for example the brokerage system is very well developed for company deposits, and this has been a unique feature of the Indian markets since 1860). As in the case of non-financial companies, financial companies are only allowed to accept deposits from the public with short-term maturities (up to 3 years), thus they do not operate in the long-term financial market. 1.55 There are also some investment companies and unit trusts which mobilize savings and invest them in industrial securities with the objective of providing a good return to savers while reducing risks through diversification. Of these companies only Unit Trust of India has a large role in the Indian financial system. Recently, since 1983 several private unit trusts or mutual funds have been set up in India. Their success will depend on management capabilities, sources of finances, cost of finance and deployment possibilities. The Government is currently contemplating the relaxation of legislation concerning mutual funds aimed at accelerating the pace of growth of the capital market, increasing competition, and providing a wider choice to investors. Mutual funds would not only mobilize larger resources for development but would also provide the basis for increased activity in secondary security markets. -22- C. STOCK AND SECURITIES MARKET 1.56 The stock market in India is regulated under the Securities Contract (Regulation) Act of 1956. At present there are twelve Stock Exchanges recognized by the Government which offer an organized market for shares and debentures of joint stock companies and for gilt-edged securities. The Bombay Stock Exchange is the leading stock market in India with the largest number and paid-up value of listed stocks. The stock market is composed of the new issue market, which is a primary market for raising new capital and the stock exchange which forms the secondary market for stocks and other securities. 1.57 The private sector as well as the Government raise funds on the stock market. A very interesting and hardly known fact about the Indian stock market is the overwhelming importance of Government securities in its volume of operations as compared to industrial securities. During 1971-72 to 1977-78, new funds mobilized through the issue of government and semi- government securities accounted for 93% to 97% of total new funds mobilized, the balance was for funds for the private corporate sector.l/ This propor- tion has been reduced somewhat in recent years due to increased activity in the private capital market since 1980. This compares with the U.K. where the government securities market is also larger than the industrial securities market (private capital market). 1. Government Securities Market 1.58 As indicated above, the Government Securities market is the largest segment of the India capital market. Government securities are issued by the Central Government, State Government, and semi-Government authorities which include local government authorities, autonomous institutions like port trusts, state electricity boards, public sector enterprises, and other government agencies, such as the All-India and regional financial institutions. Central and State Government securities outstanding stood at Rs 219.6 billion at end-March 1982, with the Central Government accounting for 84.6%. The annual net market borrowings by the Government have increased significantly over the last decade, increasing from Rs 2.3 billion in 1970/71 to Rs 28.0 billion in 1980/81 (equivalent to 32% of household financial savings). These large Government borrowings from the market (as opposed to from the banking system) allowed India to finance a large propor- tion of its Government deficit without increasing inflationary pressures. 1.59 Ownership of Government securities is concentrated in institutional investors which hold about 95% of total Government securities outstanding. In March 1982 the RBI held 23% of outstanding securities, scheduled banks 44%, LIC 11% and Provident Funds 15%. The secondary market for Government securities operating in the stock market is very narrow since institutional holders tend to keep the issues until maturity. Commercial banks, the largest holders, can buy as many securities as they want, but cannot sell 1/ "Financial Markets and Institutions", L.M. Bhole, Bombay, 1982, Tata-McGraw Hill, Chapter 15. -23- securities beyond a limit due to Statutory Liquidity Reserve (SLR) require- ments which will be analyzed later in Chapter 4. RBI's holdings allow it to act as the regulator of market prices and that explains the price stability which characterizes Indian Government securities. 1.60 Interest rates on Government securities are not aligned with other rates in the financial market. Rates are lower than on bank deposits, privately issued securities or company deposits. The main reasons for large holdings of Government securities despite low rates are: the compulsion of certain institutional investors to buy these securities (SLR requirements) and their liquidity and safety. Individuals and other non-institutional investors, such as trusts and joint-stock companies have maintained very small holdings. Ownership by individuals.is estimated at only 1% of total Government securities outstanding. 2. Private Capital Market 1.61 In India the private capital market does not constitute a major instrument to mobilize savings and channel them into investment. This is because the stock market as well as the new issue market attract an insig- nificant proportion of household savings. Recently, the Government has introduced fiscal and financial measures aimed at encouraging the flow of funds into investment in shares. Resource mobilization through the capital market has improved substantially during the past few years in response to these policies which have affected both the demand and supply side of the market. The corporate sector was encouraged to step up its efforts to raise additional resources from the capital markets by certain measures such as liberalization of industrial policy and allowing industrial firms to raise their debt-equity ratio up to 2:1. In addition, measures such as increasing the rate of interest of convertible and non-convertible debentures and recent improvement in industrial performance and corporate finances increased the interest of savers. Another measure which has increased the savers' interest in non-convertible debentures is the authorization to companies issuing such debentures to have a buy-back arrangement.l/ The further simplification of procedures relating to investment by non-residents of Indian nationality/origin and repatriation of sale proceeds of such investments also had a positive influence in the capital market. 1.62 Table 1.6 shows the significant increase in capital market activity which has occurred since 1980. Despite this overall increase in capital market activity, the mobilization of resources by the private corporate sector from this market is small when compared to household financial savings or to the capital needs of the sector. The "Rangarajan Report"2/ 1/ Under this scheme, companies can buy back non-convertible debentures at par from any debenture holder whose holding does not exceed Rs 40,000 and who has held the debentures for a period of at least one year. This was one of the recommendations made by the Working Group on Secondary market for Debentures with a view to providing liquidity to investment in non-convertible debentures short of creating an authentic secondary market. -24- estimates that in 1980/81, only 6.8Z of financial savings of the household sector were directly mobilized by the corporate sector either as securities or company deposits. It can therefore be assumed that there exists a size- able growth potential in the Indian capital market which will be tapped only by (a) improving the attractiveness of the instruments to the savers, (b) reducing the costs of intermediation and of floating of new issues, (c) strengthening the infrastructure of the capital market, encouraging the development of a secondary market, and (d) improving productivity and finan- cial performance of the corporate sector itself. The Study Group lists various measures aimed at achieving this objective which, if implemented, would go a long way in widening the base of the capital market. Table 1.6: Private Corporate Capital Issues to Public (in Rs million) 12 Months Equity & Total as a % of Net Ended June Preference Debentures Total Financial Savings /a 1979 733 384 1117 1.7 1980 1036 779 1815 2.8 1981 1705 913 2618 3.1 1982 1765 3772 5537 5.7 1983 2532 4867 7399 6.3 /a This proportion would increase substantially if we were to include company deposits as instruments of the capital market. Source: Center for Monitoring the Indian Economy, Economic Outlook, June 1983, and CSOs Quick Estimates dated January 27, 1984. 1.63 In the same vein, the Mehta/Honavar study 1/ also made several recommendations on policy and organizational changes which would increase the attractiveness of the capital markets to both savers and corporations. The main recommendations are: (a) simplify procedures for transfer of shares and reduce time spent between purchase and actual transfer of stock, (b) develop a secondary market for debentures, (c) authorize buy back arrangements of certain percentage of the debentures issue (since implemented), (d) allow banks to invest a portion of their statutory liquidity reserves on securities issued by private companies and not only in approved Government securities. 1.64 What is not very clear is whether further increases in the capital market will result in a diversion of funds from the banking system to capi- tal market instruments or whether the effect will be to increase financial 2/ Also known as the "Report of the Study Group on Financing of Private Corporate Sector in the Sixth Five-Year Plan". 1/ "Some aspects of the Indian Capital Market," S.S. Mehta and R. M. Honavar, Mimeo, 1982. -25- savings relative to saving through physical asset formation. The design and implementation of policy changes would be very much related to this question. The ideal policy should allow a shift from tangible to financial assets since this would facilitate a more efficient allocation of savings between competing uses by subjecting them to the discipline of the money and capital market. Funds could then be channeled into the most productive uses. Policy changes should further aim at increasing the returns to financial assets relative to physical assets and at reducing their invest- ment risk. In addition, policies which affect returns on financial assets should allow the growth of all different types of financial assets. 1.65 However, currently investors prefer deposits or are forced to invest in approved securities rather than in typical capital market instruments. Several measures could be taken to accelerate the development of the capital market such as those mentioned above plus: (a) changing tax policies which now make it more attractive for firms to borrow than issue equity; (b) reducing the cost of capital issues which is estimated at about 7% of the total issue; 1/ (c) amending legislation of Provident Funds to allow a proportion of them to flow into corporate securities; (d) reviewing tax exemption policies to provide appropriate incentives among different types of financial assets. 1.66 Following this line of argument, the recent Rangarajan Study Group Report highlighted the existing bias against equities as compared to low risk assets like bank deposits and UTI units which enjoy a deduction under Section 80L of the Income Tax Act. It also indicated that the bias against equities could be neutralized by exempting dividend income from taxation on a similar basis as that enjoyed by interest on deposits and income from UTI units.2/ 1/ The cost of raising capital on the market in some cases has reached 20% or more of the issue amount. The items responsible for the high issue costs are expenses on advertising, conferences, printing and supply of issue stationary, conveyance and foreign tours. Other costs are subject to statutory ceilings such as underwriting commission (3%) and brokerage fees (1.25%). Strong competition among merchant bankers have reduced management fees to about 0.5% of the issue amount. 2/ The 1983/84 Budget removed the bias towards bank deposits by cancell- ing the exemption for income tax purposes. -26- CHAPTER II MACROECONOMIC DIMENSIONS OF THE FINANCIAL SYSTEM A. EVOLUTION OF THE FINANCIAL SYSTEM: ANALYSIS OF VARIOUS INDICATORS 2.1 This section presents information on the size, growth and composi- tion of assets of financial institutions for the period 1950 through 1980. The eleven most important types of financial institutions--RBI, commercial banks, cooperative banks, post office savings system, development banks, ARDC (NABARD), Unit Trust of India, Provident Funds, life insurance companies, finance companies and other insurance companies--are differen- tiated in Table 2.1. 2.2 There are various indicators which can be used to describe the evolution of the financial system. Here we will first look at the growth and composition of assets of the financial system itself, and then we will analyze the evolution of the financial assets in the economy and will com- pare with similar data for other countries. 2.3 The assets of financial institutions (deflated by the CDP deflator) grew by 7.22% per annum in the 30-year period between 1950 and 1980, as compared to the growth of CDP of only 3.7%. Growth was not uniform throughout the period, fluctuating between 4.5% per annum in 1960-65 and 10.7% in 1975-80. Furthermore, there does not appear to be a strong cor- relation between the growth of assets of financial institutions and that of GDP. Another interesting fact that emerges from the figures is that in the period since 1968, characterized by tighter government control of the finan- cial system, particularly of commercial banks, the system grew by 8.5% per annum, faster than the long-term growth rate of 7.2%. This occurred primarily because of expansion of the banking system into rural areas and increase in branches. The data show the increased "financialization" of the Indian economy and suggest that an increased role of the public sector on the financial system does not necessarily retard its development. These trends are depicted in Chart 2.1. Table 2.1. Assets of Financial Institutions (In Billions of Rupees) Post Office unit Reserve Coinrcial Cooperative Saving Developent ARDC Trust Provident Life Ins. Finance Other Total Bank Banks Banks System Bnk (NAMED) of India Funds Coanies Comanies Insurance Assets 1950 16.54 12.50 2.03 0.63 0.11 1.42 2.88 0.23 36.42 1951 16.74 13.29 2.20 0.69 0.11 1.60 3.23 0.27 38.13 1952 15.72 12.19 2.23 0.89 0.11 1.83 3.52 0.29 36.78 1953 15.46 12.33 2.55 1.00 0.18 2.25 3.78 0.32 37.87 1954 15.61 13.77 2.89 1.21 0.21 2.69 3.63 0.35 40.36 1955 17.11 15.84 3.51 1.56 0.39 3.19 3/83 0.37 45.80 1956 19.16 17.36 4.22 1.91 0.50 3.80 4.14 0.44 51.53 1957 20.53 1.931 5.88 2.08 1.83 4.52 4.65 0.93 0.50 60.23 1958 21.74 21.52 7.21 2.25 1.95 5.20 5.05 0.97 0.53 66.42 1959 23.11 24.78 8.97 2.46 2.13 5." 5.54 1.03 C.58 74.59 1960 24.97 26.16 10.88 2.85 2.40 7.05 6.22 1.10 0.65 82.28 1961 26.44 26.63 12.86 3.22 2.70 8.22 6.96 0.95 0.73 88.71 1962 28.18 29.67 14.74 3.40 3.06 9.50 7.84 1.00 0.83 98.23 1963 30.77 33.18 17.49 3.66 3.56 0.10 11.06 8.80 1.02 0.91 110.55 1964 33.01 37.86 20.35 4.08 4.00 0.11 12.88 10.05 1.10 1.02 124.45 1965 36.12 41.71 23.16 6.12 4_03 0.11 0.25 14.86 10.95 1.19 1.13 139.63 1966 40.15 49.47 25.95 6.70 5.52 0.11 0.27 17.05 12.38 1.32 1.32 160.24 1967 43.29 53.66 29.79 7.15 6.39 0.14 0.35 19.59 13.89 1.45 1.46 177.11 1968 45.18 60.65 35.88 7.78 6.49 0.32 0.50 22.34 15.55 1.50 1.63 197.82 1969 51.16 68.71 41.50 8.41 7.25 0.63 0.67 25.86 17.45 1.56 1.89 225.09 1970 56.05 82.49 48.69 9.12 7.84 1.02 0.92 29.93 19.54 1.64 2.19 259.43 1971 64.23 94.28 55.19 9.88 9.05 1.27 1.05 35.08 22.09 1.74 2.45 296.19 1972 69.58 110.85 61.72 10.37 10.45 2.23 1.25 40.24 25.10 1.70 2.74 336.23 1973 84.37 137.70 68.65 11.31 12.06 3.10 1.52 46.27 28.76 1.86 3.07 398.76 1974 95.25 163.57 78.99 11.62 14.56 4.20 1.49 54.14 32.37 2.01 3.43 461.63 1975 109.32 200.33 87.67 11.66 18.46 5.69 1.67 64.84 36.42 2.26 3.84 542.16 1 1976 122.04 259.12 103.78 14.34 22.23 7.55 1.93 76.00 41.63 2.40 4.30 655.32 1977 141.n 314.70 118.83 15.23 28.68 9.43 2.55 89.00 47.25 2.62 4.81 774.87 1978 160.46 398.77 134.42 16.78 36.36 11.41 3.45 105.1 54.21 2.76 5.38 929.10 1979 192.86 485.24 150.55 18.53 46.31 13.94 4.35 122.6 61.77 2.99 6.02 1105.16 1 1980 228.38 582.33 180.66 20.83 58.39 17.28 4.95 142.5 70.91 3.23 6.74 1316.20 1981 265.66 22.68 75.45 21.38 5.52(est) 80.8(est.) Notes on Table "Assets of Finncial Institutions" Reserve Bank: Data taken frm DFWs IFS, various issues. Data is as of Deceuber of each year. Comircial Banks: Data taken from RBI's "Statistical Tables Relating to Banks in India', annual various. Data is as of December of each year. Cooperative Banks: Data for 1948-1978 from RBI's "Statistical Statesents relating to Cooperative Ikoveimnt in India". 1979-1980 estinstes based on partial data from "Report of Trends and Progress in Banking" (RBI). Data is as of June of following year. ot Office Savings Syatm: DI's IFS various issues. Data is as of December of each year. Development Banks: 1948-1977 data from VW's IFS end R8I's "Report on Currency and Finance (RCF) as reported by R. Goldadthl/; 1977-1980 data taken directly from RCF. Data is as of )brch of following year. 5Liculture and Rursl Develoncent Bank (ARDC1: 1963-1980 data taken from various ARDC's Annual Reports. Data is as of June of following year. Unit Trust of India CUrl): 1948-1977 Ulri's Annual Reports and RC as reported by R. Coldsmith]/; 1978-1980 data from D3I' "Report on Development Banking in India". Data is as of Decamber of each year. Provident Funds: 1948-1977 saken from Goldsmith-/; 1978-1980 extrapolated based on increases in assets from flow of funds figures. Data is as of NArch of following year. Life Insurance Cnsmanies: 1950-1980 taken from Annual Reports of LIC. Data is as of lbrch of following year. Other insurance: 1950-1970 taken from Goldsmith11; 1970-1980 etitmted applying 1950-1970 growth rate. Finance Comanies: Partial date based on data collected by BI for largest Finance and Investment companies. 1957-1970 from RBI's "Financial Statistics of Joint Stock Companies". 1970-1980 RBI's "Performance of Financial and Investment Companies" (Various RBI Bulletins). Data is as of March of following year. 1/ Table 3-17, R. Goldsamith "The Financial Development of India 1860-1977" (book published in 1983). -28- Graph 2.1 rc,;wth @;4 Fin a n C I Ass ets * I8,, CDp I' ;n conn*or,t 19'7C prios' 11 - - '7 7 ID n~~~~~~~~~~~~ 4 r 0 r I jf