Introduction - The Evolution of Indian financial system The evolution of the Indian financial system from somewhat of a constricted

and an undersized one to a more open, deregulated and market oriented one and its interface with the growth process are the major areas of analysis in this Chapter. The process of financial development in independent India hinged effectively on the development of commercial banking, with the impetus given to industrialisation based on the initiatives provided in the five year plans. Financing of emerging trade and industrial activities during the 'fifties, and the 'sixties reflected the dominance of banking as the critical source. The number of banks and branches had gone up, notwithstanding the consolidation of small banks, and the support given to co-operative credit movement1. Functionally, banks catered to the needs of the organised industrial and trading sectors. The primary sector consisting of 'agriculture, forestry and fishing' which formed more than 50 per cent of GDP during this period had to depend largely on own financing and on sources outside the commercial banks. It is against this backdrop that the process of financial development was given impetus with the adoption of the policy of social control over banks in 1967, reinforced in 1969 by the nationalisation of 14 major scheduled commercial banks. Since then, the banking system has formed the core of the Indian financial system. Driven largely by the public sector initiative and policy activism, commercial banks have a dominant share in total financial assets and are the main source of financing for the private corporate sector. They also channel a sizeable share of household savings to the public sector. Besides, in recent years, they have been performing most of the payment system functions. With increased diversification in recent years, banks in both public and private sectors have been providing a wide range of financial services. In the three decades following the first wave of bank nationalisation (the second wave consisted of six commercial banks in 1980), the number of scheduled commercial banks has quadrupled and the

number of bank branches has increased eight-fold. Aggregate deposits of scheduled commercial banks have increased at a compound annual average growth rate of 17.8 per cent during this period (1969 to 1999), while bank credit expanded at a rate of 16.3 per cent per annum. Banks' investments in government and other approved securities recorded a growth of 18.8 per cent per annum. The increased role of bank intermediation is also reflected in its payment system activities. The total cheque clearances have gone up by 2175 times during this period, spurred by a qualitative shift from a manual to an electronic cheque clearing system. The financial system outside the banks has also exhibited considerable dynamism. The system today is varied, with a welldiversified structure of financial institutions, financial companies and mutual funds. Financial institutions comprise all-India Financial Institutions (AIFIs), State-level Institutions (SFCs and SIDCs) and other institutions (ECGC and DICGC).2 AIFIs include all-India Development Banks (IFCI, ICICI, IDBI, SIDBI and IIBI), specialised institutions (EXIM Bank, IVCF, ICICI Venture, TFCI and IDFC), investment institutions (UTI, LIC and GIC and its subsidiaries) and refinance institutions (NABARD and NHB). The setting up of some specialised financial institutions and refinance institutions during last three decades and the onset of reforms from about the early 'nineties, provided depth to the financial intermediation outside the banking sector. These developments, coupled with increased financial market liberalisation, have enhanced competition. A number of the existing financial institutions have diversified into several new activities, such as, investment banking and infrastructure financing, providing guarantees for domestic and offshore lending for infrastructure projects. Apart from the financial institutions, rapid expansion of Non-Banking Financial Companies (NBFCs) took place in the 'eighties and provided avenues for depositors to hold assets and for borrowers to enhance the scale of funding of their activities. Various types of NBFCs have provided varied services that include

equipment leasing, hire purchase, loans, investments, mutual benefit and chit fund activities. More recently, NBFC activity has picked up in the area of housing finance. Financial development is also reflected in the growing importance of mutual funds. In the 'nineties, they have enabled sizable mobilisation of financial surpluses of the households for investment in capital markets. Capital markets themselves have become an important source of financing corporate investments, especially after firms were permitted to charge share premium in a flexible manner. Sanctions as well as disbursements of all-financial institutions, including the SFCs and the SIDCs has expanded at a rate of 24.1 per cent per annum and 23.8 per cent per annum, respectively, during 1970-71 to 1999-2000. In addition, there has been a spurt in the activities of NBFCs and mutual funds over the last two decades. Deposits of NBFCs recorded an impressive growth of about 35 per cent per annum from the mid-'eighties to the middle of the 'nineties. In the 'sixties and 'seventies, the Unit Trust of India (UTI) was the only mutual fund. By 1999-2000 as many as 34 mutual funds were operating of which 7 mutual funds were set up by the public sector banks and financial institutions. Their total resource mobilisation in 1999-2000 was nearly Rs. 22,000 crore, with 78 per cent of this having been mobilised by the private sector mutual funds. The financial development in the banking and non-bank financial sector has supported saving and investment in the economy and contributed to growth in real activity. By pooling risks, reaping economies of scale and scope, and by providing maturity transformation, financial intermediation supports economic activity of the non-financial sectors. Its influence on growth, however, needs to be examined from different viewpoints that are of potential relevance in the Indian context. Banking-based Indicators of Financial Development

The banking system in India consists of commercial banks and cooperative banks, but it is the former which is dominant in terms of deposits, advances and investments. Commercial banks include foreign banks operating in India in addition to Indian banks in the public sector and the private sector, including Regional Rural Banks. Since 1969, the commercial banks, after nationalisation of 14 banks, have made rapid strides in all the spheres of banking operations, be it the mobilisation of deposits, deployment of credit or geographical coverage, and have accounted for most of the growth in the banking system. Illustratively, while the number of scheduled commercial banks has gone up moderately, the number of bank offices in India expanded nearly eight-fold from 8,262 in June 1969 to 67,339 in March 2000, as a result of which the population per bank office improved from 64,000 to 15,000 over the same period. Both per capita deposit and per capita credit have witnessed manifold growth. While per capita deposit expanded from a mere Rs.88 in 1969 to Rs.8,247 in 1999-2000, per capita credit, over the same period, expanded from Rs.68 to Rs.4,705; the increase in both these indicators was more pronounced since the latter half of the 'eighties. Development Financial Institutions Development financial institutions (DFIs) were established in India to resolve a typical market inadequacy problem, viz., the shortage of long-term resources and the perceived risk aversion of savers and creditors to part with funds for long gestation projects. In view of the inadequate provision of long-term finance through banks and/or markets, many of these institutions were set up by the Government. The endorsement of planned industrialisation at the national level provided the critical inducement for establishment of DFIs at both the all-India and state levels. Besides DFIs at the national and state levels, there are also investment institutions and specialised financial institutions. These institutions provided financial assistance in the form of term loans, underwriting/direct

subscription to shares/debentures and guarantees. There has been a secular increase in the disbursements of financial institutions. As a percentage of GDP, disbursements by financial institutions rose from as low as 0.5 per cent in the first-half of the 'seventies to 1.4 per cent in the first-half of the 'eighties. The ratio increased further to 2.9 per cent in the first-half of the 'nineties and stood at 3.3 per cent in the second-half of the 'nineties. Mutual Funds Mutual funds provide households an option for portfolio diversification and relative risk-aversion through collection of funds from the households and make investments in the stock and debt markets. Resources mobilised by mutual funds (UTI was the only mutual fund until 1987-88) grew at a steady rate until 1992-93; since then they showed some variations. Resources mobilised by mutual funds which was just 0.04 per cent of GDP (at current market prices) during the period 1970-71 to 1974-75 increased to 1.59 per cent during 1990-91 to 1992-93. Total resources mobilised as proportion of GDP declined to 1.12 per cent by 1994-95 but nevertheless remained positive. During the period from 1995-96 to 1996-97, there was a net outflow of funds from mutual funds, especially UTI, as a result of which the ratio turned negative. From 1997-98 onwards, the ratio again turned positive and stood at 1.13 per cent during 1999-2000. Non-Banking Financial Companies Non-banking financial companies (NBFCs) have emerged as an important part of the Indian financial system. These companies have grown rapidly in the second-half of the 'eighties and the first-half of the 'nineties. The regulated deposits of NBFCs increased from an average of 0.12 per cent of GDP during the period from 1970-71 to 1974-75 to 0.30 per cent during the period from 1985-86 to 198990. They witnessed a steady growth thereafter to 0.45 per cent of GDP during 1990-91 to 1992-93. During the period 1993-94 to

1996-97, they experienced a sharp rise from 2.02 per cent of GDP to 3.90 per cent. In recent years, however, deposits with NBFCs have witnessed a decline. The trend in the growth in total deposits with NBFCs as a percentage of aggregate deposits exhibited more or less similar trend, rising from a low of 0.71 per cent of bank deposits during the period from 1970-75 to 1.18 per cent during 1990-93. During the period from 1993-94 to 1996-97, deposits with NBFCs experienced a sharper rise from 5.02 per cent of commercial bank deposits to 9.47 per cent. Recent years have, however, witnessed relatively lower ratios. This could be attributed partly to the setting up of a strong regulatory and supervisory framework and partly to changes in the definition of deposits