INTERNAL RESEARCH ASSIGNMENT

Name of the candidate: HARNEET KAUR

Enrollment No. : 05115903914
Course:

MBA-III MORNING-A

Batch:

2014-16

Subject:

FINANCIAL MARKETS & INSTITUTIONS

Subject code:

MS 219

Topic of assignment:

FINANCIAL SECTOR REFORM

Subject Teachers name:

MS. NIDHI SHARMA

Question: Critically discuss about the recommendations of Raghuram Rajan Committees report
on Financial Sector Reform.
Answer: The draft report of the Committee on Financial Sector Reforms, chaired by Raghuram
Rajan, follows on the earlier Mistry committee report on developing Mumbai as an international
financial centre. The reports are complementary in their focuson domestic and international
markets, respectivelyand very similar in perspective and recommendations.
Despite current global financial uncertainties, and a potential backlash against financial
liberalization, the two reports have done a great job of agenda-setting, which will be extremely
fruitful in coming years.
The agenda of the latest report is politically more urgent since it addresses financial inclusion
and domestic financial development, but this also means that the political challenges of
implementation will be greater. Even when reform consists of a hundred small steps, the
complementary nature of many of these steps, and the need for foundational changes in systemic
underpinnings complicates the process. Beyond debating the merits of particular proposals in the
report, it is therefore important to analyse the categories of proposed reforms and identify a
feasible core that can be pursued immediately.
The recommendations on the macroeconomic framework are likely to be the most controversial
and most resisted. Inflation targeting and a floating exchange rate are very far from current
Indian practice. The viewpoint embodied in these proposals accords with the weight of academic
opinion, but is not unanimously held or empirically ironclad. The debate will likely continue for
some time, but it is critical to recognize that most of the financial sector reform proposals in the
Rajan report do not depend on or require changes in the macroeconomic framework, even if the
present approach seems a bit like muddling through.
Similarly, there are several recommendations for modifying the current regulatory architecture,
designed to improve coordination, coverage and quality. A key idea is the reduction of
micromanagement. Certainly, structural changes can help improve regulatory incentives, but
again there is a danger of getting bogged down in setting up new institutions or making
legislative changes. Indeed, the report acknowledges a sound regulatory framework exists,
albeit with deficiencies. My own sense is that much can be accomplished by an attitudinal

change in the Reserve Bank of India (RBI), which has considerable leeway to streamline
regulatory implementation within existing laws and institutions.
Where RBI will need outside help is in creating an appropriate credit infrastructure. This is one
of the most important parts of the report. Credit markets require mechanisms for building and
assessing reputations, providing collateral and enforcing agreements. Clear and streamlined
procedures for default and bankruptcy are also critical. All of this is an area where several small
steps are feasible, and clearly laid out in the report. However, key changes in bankruptcy law,
already proposed by an earlier committee (chaired by J.J. Irani in 2005) should be a high priority.
Another important aspect of improved credit infrastructure will be doing a better job of
informing, educating and protecting small participants in financial marketsthis is, in fact, the
chief micro lesson of the US subprime crisis, and is an important area for regulatory reform.
The current approach to protection of market participants is very different various transactions,
markets and participants are simply banned. This brings one to the heart of needed reform. India
can progress by building on its demonstrated success of creating modern, efficient markets in
financial instruments. The report provides clear and blunt guidance in this area: encourage the
introduction of missing markets; stop creating investor uncertainty by banning markets; have
consolidated membership of exchanges for qualified investors; encourage the setting up of
professional markets and exchanges for sophisticated products and investors; and create a
more innovation-friendly environment, speeding up the process for approval of new financial
products.
Doing all this wont automatically increase financial inclusion, but it will begin to create a
modern financial sector. Ultimately, exchange-traded financial securities reduce the costs of more
traditional and idiosyncratic forms of borrowing and lending. Again, putting aside the fraud and
negligence behind the current subprime crisis, securitization of mortgages and trading of those
securities has been crucial in reducing costs in, and expanding access to, the US mortgage
market. Banks and other retail financial institutions still have to exist, and can be made more
efficient: increased entry and competition, smaller burdens on public sector banks, improvements
in organization and in use of technology, and consolidation are all rightly recommended in the
Rajan report.
Finally, it is good to remind ourselves that real sector reforms are also necessary, as the report
points out. Thus, better insurance coverage in areas such as agriculture and health is needed, but

so are irrigation and preventive health care, as ways of reducing the actual risks. The optimistic
way to look at the broad canvas of reforms in India is that there is so much potential to make
things better.
Sticking to its theme of financial inclusion and making credit available for small borrowers, the
Reserve Bank of India granted in-principle licences to set up small finance banks to 10
applicants, all microfinance companies. In fact, even among the various microfinance applicants,
the central bank seems to have left out large players and chosen to go with those with more
modest sizes.
Among the 10 applicants that got the licence were Ujjivan Financial Services, Equitas Holdings,
Janalakshmi Financial Services, Suryoday Micro Finance and Utkarsh Micro Finance. Ujjivan
has an outstanding loan portfolio of Rs 3,300 crore and operates in 24 states and Union
Territories currently. Its net profit in 2013-14 was Rs 55 crore.
Utkarsh Microfinance has a loan book of Rs 920 crore and has a 7.5 lakh customer base.
In total, there were 72 applicants ranging from individuals, microfinance companies, housing
finance companies and even non-financial companies. None of the 12 individual applicants got a
licence approval and even big lenders such as Dewan Housing Finance, SKS Microfinance and
Repco Microfinance lost out.
Small finance banks were deemed to be a stepping stone towards conversion to full service banks
eventually.RBI governor Raghuram Rajan had also said the central bank expects some of the
small finance bank licencees to scale up eventually and opt to be universal banks. In fact,
Janalakshmi Financial Services will opt for a non-operating financial holding company structure
so that it can eventually turn into a universal bank with ease.
However, that the licences have been given to small players indicates the central bank wants the
spirit of financial inclusion to be preserved and these new players to concentrate on small
borrowers.
Said VS Radhakrishnan, MD & CEO, Janalakshmi Financial Services: We will ensure that we
create the right structure to comply with all the conditions laid down by RBI and we are
confident we will be able to do it. Our intention is to convert Janalakshmi into a bank and create
a NOFHC structure that RBI had suggested under the universal bank category. He added: So,
we will create a promoter company and Janalakshi will become the bank.

We have the capital that we need and have to finalise the structure to comply with the
requirements. We will perhaps need more capital for growth and, given that, we hope to have
both our existing investors and new investors who'd be happy with the progress and participate in
it.
Guidelines set out by the RBI in November last year mandate small finance banks to lend 75% of
their advances to the priority sector and not less than half of their loan book should be of loans of
up to Rs 25 lakh. Microfinance companies which have got licences said that the norms on
lending would be easily met and in fact give scope to expand their operations. Our average loan
size is Rs 12,000, so we have immense scope to lend higher ticket size, said Govind Singh,
founder and MD&CEO of Utkarsh Micro Finance.
Small finance banks can also distribute simple third-party financial products, such as mutual
funds and insurance schemes, but cannot be business correspondents of other banks, as per the
guidelines.
Also, microfinance lenders said meeting the minimum capital requirement of Rs 100 crore to set
up a small finance bank would be easy. We have over Rs 700 crore in capital and we have been
in operation for 10 years and capital is not an issue, said Samit Ghosh, managing director and
chief executive officer at Ujjivan Financial Services.
Further, the central bank mandates that promoter holding should be minimum 40% of equity
capital, but must be brought down to 30% in ten years time. The foreign shareholding is capped
at 74% of paid-up capital. Suryoday Micro Finance will convert itself into a bank while making
the necessary changes in shareholding to comply with the norms, said Bhaskar Babu, co-founder
of the company.
According to Ghosh, Ujjivan will have to convert its ownership as it is pre-dominantly foreignowned. We have to convert our ownership structure to a domestic entity, which will be a big
challenge. At the same time, we have to build a business model that has to be unique, keeping in
mind the customer base and learning from other financial institutions across the world who have
served this customer base using technology, said Ghosh.

POLICY RECOMMENDATIONS
Based on the analysis, the Committee proposes the steps below as a means to upgrade the policy
framework to meet the challenges that lie ahead. The Committee emphasizes that these
recommended reforms should be seen as a package. Implementing them partially would make

the individual reforms far less effective; indeed, the Committee cautions that implementing the
recommendations selectively could in some cases be counterproductive. For instance,
liberalizing external commercial borrowings by corporates without allowing for greater exchange
rate flexibility would increase incentives for borrowing via foreign currency-denominated debt,
which could be risky. The Committee views proper sequencing of the recommended reforms as
important but, rather than lay out a specific and rigid timeline, prefers to take a more practical
approach of indicating which reforms could be undertaken in the short run (the next12 years)
and which ones should be seen as longer-term objectives (over a 35 year horizon).

Monetary policy
Move towards establishing RBIs primary objective as the maintenance of low and stable
inflation. Implicit in this objective will be to maintain growth consistent with the
economys potential and to ensure financial sector stability. The objective could be
translated quantitatively into a number, a number that can be brought down over time, or
a range that will be achieved over a medium-term horizon (say, two years). This will have
to be done with the full support of the government, which would simultaneously commit
to maintain fiscal discipline (i.e., stick to the FRBM deficit reduction path) and not hold
the central bank accountable for either the level or volatility of the nominal exchange
rate. The inflation objective would initially have to be set on the basis of a widelyrecognized indicator such as the WPI or CPI, notwithstanding the conceptual and
practical problems with targeting these measures of inflation. Measurement issues will
need to be tackled as a priority and, over the initial medium-term horizon, the RBI will
have to be transparent about what its headline objective implies for inflation based on
other price indexes.
o The government would make the RBI accountable for the medium-term inflation
objective, with the terms of this accountability initially being laid out in an
exchange of letters between the Government of India and the RBI.
o The RBI should be given full operational independence to achieve the inflation
objective. It would be useful to enshrine this operational independence and the
inflation objective in legislation, but also strengthen it through clarifying public
statements on the respective roles of the RBI and the government.

o The RBI would progressively reduce its intervention in the foreign exchange
market.
o The RBI should make its operational framework clear, and supplement this with
more frequent and concise statements about its assessments of macroeconomic
developments, the balance of risks in the economy, and projections for output
o

growth and inflation.

The RBIs Monetary Policy Committee should take a more active role in guiding
monetary policy actions. This Committee should meet more regularly; its
recommendations and policy judgments should be made public with minimal

delays.
o The RBI should develop a model for forecasting inflation and make the details of
the model public. The model will require refinement as techniques and data
improve; feedback from analysts and academics will facilitate this process. It will
have to be made clear (and the public and market participants will quickly learn)
that the model is intended to guide monetary policy decisions but not in a slavish
manner or in a manner that precludes a healthy dose of judgement.
Timing: Steps 1, 2 and 4 could be implemented in the short term. Legislation (step 3)
could take longer to formulate and pass, but it is important that the other steps be
implemented and tied to a clear public understanding between the government and the
RBI. Steps 57 should be implemented soon, especially since they are refinements
(although fairly substantive ones) to current practices.

Capital account
o Remove restrictions on outflows by corporates and individuals. There are already
few restrictions on these outflows, but formal removal of controls, easing of
procedures and elimination of the need for permissions, as well as a strong push
to encourage outward flows would send a strong signal that the government is
committing to increased financial integration and the policies that are needed to
support it. Easing of restrictions on vehicles such as mutual funds and domestic
fund managers, that individuals could use for international portfolio
diversification, would be an important ancillary reform.
o The registration requirements on foreign investors should be simplified. One
transparent approach would be to end the foreign institutional investor (FII)

framework for investment in equities and, instead, allow foreign investors

(including NRIs) to have direct depository accounts. The distinctions between
FIIs, NRIs and other investors could also be eliminated, with the intent being to
eliminate any privileges or costs they may experience with respect to domestic
investors.
o Remove the ceilings on foreign portfolio investment in all companies, with a
narrow exception for national security considerationstreat foreign investors just
like local shareholders.
o Remove restrictions on capital inflows based on end-uses of funds. These do not
serve much purpose anyway, since they are difficult to monitor.
o Remove restrictions on inward FDI, with a narrow exception for national security
considerations.
o Liberalize, then eliminate, restrictions on foreign investors participation in rupee
denominated debt, including corporate and government debt.
o Remove regulations that hinder international diversification by domestic
institutional investors. Insurance companies, as well as government pension and
provident funds should especially be encouraged to diversify their holdings by
investing abroad.
o Reduce restrictions on borrowing by domestic firms and banks, whether this
borrowing occurs offshore or onshore, in Indian rupees or foreign currencies. For
instance, the ceiling on corporate external commercial borrowing could be
steadily raised for the next few years until eliminated. If there is excess demand
during the transitional phase to removal of restrictions, borrowing rights could be
auctioned.17 Stability concerns raised by exchange mismatches between bank
assets and liabilities should be addressed by supervisory and prudential measures.
Timing: The first four steps would essentially formalize existing de facto arrangements
and remove impediments that serve no substantive purpose in terms of economic
efficiency or macro management. These changes could be implemented relatively
quickly. Steps 56 could be implemented over the short term, in tandem with other
reforms including improvements in the structure of public debt management. Step 7
could be implemented over 23 years. This lag is to allow for adequate regulatory
capacity to be built up, and to allow for public debt management to be improved and for

foreign investors to be allowed to participate in domestic debt markets so that there are
no major implications for financing of the public debt.

Fiscal policy
o Continue to reduce levels of consolidated government deficit and public debt
(ratios to GDP); resume progress towards targets specified under the Fiscal
Responsibility and Budget Management Bill. Amend the FRBM Act so as to bring
the off-balance-sheet borrowing by the government integrally into calculations of
the government budget deficit and public debt.
o Reduce the Statutory Liquidity Ratio to a level consistent with prudential needs;
switch to direct bond financing of new deficits. Similarly, regulators of pension
funds and insurance companies should set regulations on fund portfolio holdings
so as to maximize the welfare of beneficiaries, and not so as to mobilize the
purchase of government bonds.
o Transition away from providing sops for exporters in response to currency
appreciation. While many of the recent sops are in the process of being removed,
it is important to curtail expectations of similar sops being offered in the future in
the event of currency appreciation.
Timing: The time horizon for some of these measures could be in the range of 12 years,
but it is essential to start laying the foundation for some of these changes much sooner.

Other reforms

o Remove the remaining restrictions on the currency futures market in the short
term (prohibitions against foreign institutional investors, against non-resident
Indians, against products other than futures, against underlying trades other than
the rupeeUS dollar rate, and against positions greater than US$5 million).
Permitting onshore currency derivatives markets with no restrictions on
participation is an important measure that includes elements of financial market
regulation as well as capital account liberalization. These markets could be
developed fairly quickly as the technical infrastructure for trading of these
derivatives could be built up soon on the backbone of the existing securities
trading infrastructure.
o Improve the structure of public debt management to increase depth and
transparency of this market. The Committee is pleased to note that the RBI is

working on the first item and the Finance Ministry has announced that it is setting
up a public debt management office. These measures are long overdue and should
be implemented soon. The set of reforms listed here has not touched upon broader
issues, some of which were discussed in the main text of the chaptereasing of
labour market regulations, increasing investment in physical infrastructure and
education, reducing red tape, improving data collection, etc. Action on all of these
fronts will ultimately determine Indias growth trajectory. But the specific steps
listed above will make a major contribution to achieving the desired trajectory and
could generate momentum for broader reforms.

PLAGIARISM REPORT: