Multiplicity of Financial Instruments

• The expansion in size and number of financial institutions has

consequently led to a considerable increase in the financial
instruments also.
• New instruments have been introduced in the form of innovative
schemes of LIC, UTI, Banks, Post Office Savings Bank Accounts, Shares
and debentures of different varieties, Public Sector Bonds, National
Savings Scheme, National Savings Certificates, Provident Funds, Relief
Bonds, Indira Vikas Patra, etc.
• Thus different types of instruments are available in the financial
system so as to meet the diversified requirements of varied investors
and thereby making the system more healthy and vibrant.
WEAKNESSES OF INDIAN FINANCIAL SYSTEM
1. Lack of Co-ordination between different Financial Institutions:
• There are a large number of financial intermediaries. Most of the vital
financial institutions are owned by the Government.
• At the same time, the Government is also the controlling authority of
these institutions.
• In these circumstances, the problem of co-ordination arises. As there
is multiplicity of institutions in the Indian financial system, there is
lack of co-ordination in the working of these institutions.
2. Monopolistic Market Structures
• In India some financial institutions are so large that they have created
a monopolistic market structures in the financial system.
• For instance the entire life insurance business is in the hands of LIC.
The UTI has more or less monopolized the mutual fund industry.
• The weakness of this large structure is that it could lead to
inefficiency in their working or mismanagement or lack of effort in
mobilizing savings of the public and so on.
• Ultimately it would retard the development of the financial system of
the country itself.
3. Dominance of Development Banks in
Industrial Financing
• The development banks constitute the backbone of the Indian
financial system occupying an important place in the capital market.
• The industrial financing today in India is largely through the financial
institutions created by the Government both at the national and
regional levels.
4. Inactive and Erratic Capital Market
• The important function of any capital market is to promote economic
development through mobilization of savings and their distribution to
productive ventures.
• As far as industrial finance in India is concerned, corporate customers
are able to raise their financial resources through development banks.
So, they need not go to the capital market.
5. Imprudent Financial Practice
• The dominance of development banks has developed imprudent financial
practice among corporate customers.
• The development banks provide most of the funds in the form of term
loans.
• So there is a preponderance of debt in the financial structure of corporate
enterprises.
• This predominance of debt capital has made the capital structure of the
borrowing concerns uneven and lopsided.
• To make maters worse, when corporate enterprises face any financial
crises, these financial institutions permit a greater use of debt than a
warranted. It is against the traditional concept of a sound capital structure.
New Financial Instruments in India
Narasimham Committee Report 1991 1998 -
Recommendations
Problems Identified By The Narasimham
Committee
1. Directed Investment Programme :
• The committee objected to the system of maintaining high liquid
assets by commercial banks in the form of cash, gold and
unencumbered government securities.
• It is also known as the statutory liquidity Ratio (SLR). In those days, in
India, the SLR was as high as 38.5 percent. According to the M.
Narasimham's Committee it was one of the reasons for the poor
profitability of banks.
• Similarly, the Cash Reserve Ratio- (CRR) was as high as 15 percent.
Taken together, banks needed to maintain 53.5 percent of their
resources idle with the RBI
2. Directed Credit Programme :
• Since nationalization the government has encouraged the lending to
agriculture and small-scale industries at a confessional rate of
interest.
• It is known as the directed credit programme. The committee opined
that these sectors have matured and thus do not need such financial
support.
• This directed credit programme was successful from the
government's point of view but it affected commercial banks in a bad
manner. Basically it deteriorated the quality of loan, resulted in a shift
from the security oriented loan to purpose oriented.
• Banks were given a huge target of priority sector lending, etc.
ultimately leading to profit erosion of banks.
3. Interest Rate Structure
• The committee found that the interest rate structure and rate of
interest in India are highly regulated and controlled by the
government.
• They also found that government used bank funds at a cheap rate
under the SLR.
• At the same time the government advocated the philosophy of
subsidized lending to certain sectors.
• The committee felt that there was no need for interest subsidy. It
made banks handicapped in terms of building main strength and
expanding credit supply.
4. Additional Suggestions
• Committee also suggested that the determination of interest rate
should be on grounds of market forces.
• It further suggested minimizing the slabs of interest.
Narasimham Committee Report I - 1991
• The Narsimham Committee was set up in order to study the problems
of the Indian financial system and to suggest some recommendations
for improvement in the efficiency and productivity of the financial
institution.
1. Reduction in the SLR and CRR :
• The committee recommended the reduction of the higher proportion
of the Statutory Liquidity Ratio 'SLR' and the Cash Reserve Ratio 'CRR’.
• Both of these ratios were very high at that time. The SLR then was
38.5% and CRR was 15%.
• This high amount of SLR and CRR meant locking the bank resources
for government uses. It was hindrance in the productivity of the bank
thus the committee recommended their gradual reduction.
• SLR was recommended to reduce from 38.5% to 25% and CRR from
15% to 3 to 5%.
2. Phasing out Directed Credit Programme
• In India, since nationalization, directed credit programmes were
adopted by the government.
• The committee recommended phasing out of this programme.
• This programme compelled banks to earmark then financial resources
for the needy and poor sectors at confessional rates of interest.
• It was reducing the profitability of banks and thus the committee
recommended the stopping of this programme.
3. Interest Rate Determination
• The committee felt that the interest rates in India are regulated and
controlled by the authorities.
• The determination of the interest rate should be on the grounds of
market forces such as the demand for and the supply of fund.
• Hence the committee recommended eliminating government controls
on interest rate and phasing out the concessional interest rates for
the priority sector.
4. Structural Reorganizations of the Banking
sector
• The committee recommended that the actual numbers of public
sector banks need to be reduced.
• Three to four big banks including SBI should be developed as
international banks. Eight to Ten Banks having nationwide presence
should concentrate on the national and universal banking services.
• Local banks should concentrate on region specific banking. Regarding
the RRBs (Regional Rural Banks), it recommended that they should
focus on agriculture and rural financing.
• They recommended that the government should assure that
henceforth there won't be any nationalization and private and foreign
banks should be allowed liberal entry in India.
5. Establishment of the ARF Tribunal
• The proportion of bad debts and Non-performing asset (NPA) of the
public sector Banks and Development Financial Institute was very
alarming in those days.
• The committee recommended the establishment of an Asset
Reconstruction Fund (ARF).
• This fund will take over the proportion of the bad and doubtful debts
from the banks and financial institutes. It would help banks to get rid
of bad debts.
6. Removal of Dual control
• Those days banks were under the dual control of the Reserve Bank of
India (RBI) and the Banking Division of the Ministry of Finance
(Government of India).
• The committee recommended the stepping of this system. It
considered and recommended that the RBI should be the only main
agency to regulate banking in India.
7. Banking Autonomy
• The committee recommended that the public sector banks should be
free and autonomous.
• In order to pursue competitiveness and efficiency, banks must enjoy
autonomy so that they can reform the work culture and banking
technology upgradation will thus be easy.
Narasimham Committee Report II - 1998
• In 1998 the government appointed yet another committee under the
chairmanship of Mr. Narsimham.
• It is better known as the Banking Sector Committee. It was told to
review the banking reform progress and design a programme for
further strengthening the financial system of India.
• The committee focused on various areas such as capital adequacy,
bank mergers, bank legislation, etc.
1. Strengthening Banks in India
• The committee considered the stronger banking system in the context
of the Current Account Convertibility 'CAC’.
• It thought that Indian banks must be capable of handling problems
regarding domestic liquidity and exchange rate management in the
light of CAC.
• Thus, it recommended the merger of strong banks which will have
'multiplier effect' on the industry.
2. Narrow Banking
• Those days many public sector banks were facing a problem of the
Non-performing assets (NPAs).
• Some of them had NPAs were as high as 20 percent of their assets.
• Thus for successful rehabilitation of these banks it recommended
'Narrow Banking Concept' where weak banks will be allowed to place
their funds only in short term and risk free assets.
3. Capital Adequacy Ratio
• In order to improve the inherent strength of the Indian banking
system the committee recommended that the Government should
raise the prescribed capital adequacy norms.
• This will further improve their absorption capacity also. Currently the
capital adequacy ration for Indian banks is at 9 percent.
4. Bank ownership
• As it had earlier mentioned the freedom for banks in its working and
bank autonomy, it felt that the government control over the banks in
the form of management and ownership and bank autonomy does
not go hand in hand and thus it recommended a review of functions
of boards and enabled them to adopt professional corporate strategy.
5. Review of banking laws
• The committee considered that there was an urgent need for
reviewing and amending main laws governing Indian Banking Industry
like RBI Act, Banking Regulation Act, State Bank of India Act, Bank
Nationalisation Act, etc.
• This upgradation will bring them in line with the present needs of the
banking sector in India.
• Apart from these major recommendations, the committee has also
recommended faster computerization, technology upgradation,
training of staff, depoliticizing of banks, professionalism in banking,
reviewing bank recruitment, etc.
Indicators of Financial Development