6.154 Interest rates in the inter-bank market (call rate) and the government securities market (proxied by 91-day treasury bill rate) displayed a high degree of positive correlation between April 1993-September 2002. As commercial banks often arbitrage between their balances with the Reserve Bank in view of reserve requirements on an average basis and their investments in gilts, especially after the introduction of daily repo/reverse repo auctions under LAF, this, in turn, creates an informal corridor of interest rates created by the lending (reverse repo) and deposit (repo) rates of the Reserve Bank. Positive correlation is registered between the foreign exchange market (proxied by the forward premia) and the money market (proxied by call money rate) especially as the gradual flexibility accorded to banks in respect of their nostro investments allowed them to operate across the two markets (Chart VI.25). An increase (decrease) in the forward premia typically pushes up (pulls down) the call rates, especially if banks fund foreign exchange positions through call borrowings.

6.155 There is a negative correlation between movements in the equity prices and the forward premia, partly reflecting the operations of foreign institutional investors. The portfolio allocations of FIIs are guided by returns earned in the Indian vis-à-vis foreign markets. The money market and the equity market were found to be negatively correlated. The relationship, however, was found to be weak.

6.156 Thus, analysis of correlation coefficients suggests that various market segments are integrated in varying degrees. Integration of financial markets was found to be more pronounced during the episodes of volatility in the financial markets, which began during the mid-1990. For example, sharp changes in overnight interest rates tend to impact longer-run gilt prices, especially in the case of sharp movements (Chart VI.26). It was also observed that excess returns emerged contemporaneously across market segments – call money, treasury bills and forwards – in the first half of 2000-01 during the extended bout of financial market volatility. The excess returns tended to vanish with the restoration of stability during October-November 2000. Furthermore, there was a close correlation between the movements in the bid-ask spread in the foreign exchange market and the Government securities market and the high-low spread (of the BSE Sensex) in the equity markets during 2000-01, especially during times of uncertainty such as the terrorist attacks in the US (on September 11, 2001) and at the Indian Parliament (on December 13, 2001) (Charts VI.27 and VI.28).

6.157 To sum up, financial sector reforms have been successful in bringing significant improvements in various market segments. Reforms have helped in improving the depth, liquidity and efficiency of markets. The money market is now reasonably developed with an array of instruments. The character of the Government securities market has changed from a captive market to a broad-based market. It has also become deep and liquid, which has enabled the Reserve Bank to pursue its monetary policy through market-based instruments. Various reform measures have resulted in sharp growth of the foreign exchange market. Reforms have also been successful in creating, by and large, orderly conditions in the market. The capital market has become a safer place for investors as various risks involved at various stages of trading and settlement have been either completely eliminated or reduced considerably. Liquidity in the stock market has improved considerably. Various market segments have also become inter-linked. However, it needs to be noted that various market segments are still developing and there are some deficiencies, which need to be removed. In the case of money market, the term money market segment has not yet developed. Depth and liquidity of the government securities market and the foreign exchange market need to be improved further. The capital market has yet to show signs that it is processing the information more efficiently than before reforms. Various market segments also need to be integrated further.

6.158 Financial sector reforms introduced in the early 1990s in a gradual and sequenced manner, were directed at the removal of various deficiencies from which the system was suffering. The basic objectives of reforms were to make the system more stable and efficient so that it could contribute in accelerating the growth process.

6.159 The most significant achievement of financial sector reforms has been a marked improvement in the financial health of the commercial banking sector, which constitutes the most important segment of the Indian financial system. Asset quality of commercial banks, which before the initiation of reforms was at a very precarious level, improved significantly even as the norms were tightened over the years and the economy slowed down. Capital position of commercial banks also improved significantly and was somewhat higher than the prescribed level. Profitability of the commercial banking sector improved despite decline in spread , which itself is a measure of efficiency. Although commercial banks still face the problem of overhang of NPAs, high spread and low profitability in comparison with banks in other emerging market economies, reforms have been successful in enhancing the performance of commercial banks in terms of both stability and efficiency parameters.

6.160 The empirical evidence suggests that public ownership impinged on the efficiency of the banking sector as old private sector banks and those PSBs, which divested their equity recently, outperformed fully Government-owned banks. However, significant improvement was observed in the performance of fully Government-owned banks in the recent years and their performance tended to converge with that of other bank groups. In the context of the Indian banking sector, it was found empirically that various measures introduced to enhance the stability of the Indian banking system have not adversely affected their efficiency. In fact, stability and efficiency measures were found to be mutually reinforcing and complimentary.

6.161 While commercial banking sector showed significant improvement, the impact was not so evident in respect of other financial intermediaries operating in the system. Co-operative banking sector as a group did not show any improvement in either the stability or efficiency parameters. The state cooperative banks and district co-operative banks, which were incurring losses, turned around and made profits. However, asset quality and profitability of scheduled urban co-operative banks deteriorated in the recent years. Although one reason for this appears to be late start of the reform process for the co-operative banks in comparison with commercial banking sector, the condition of co-operative banks remains a cause of concern. DFIs, which traditionally played an important role in financing investment activity, find themselves at the crossroad. In the initial phase of reform, DFIs were able to sustain their business and profitability due to several factors, which worked to their advantage. However, on the whole, they have not been able to sufficiently reposition themselves in the changed operating environment. While all DFIs are able to maintain adequate CRAR, the profitability and asset quality of some of them are becoming a cause of concern.

6.162 NBFCs have been witnessing significant changes. While the capital adequacy position of most of the NBFCs improved in the recent years, their profitability was adversely affected due mainly to rise in the cost of funds. This, in turn, was due to decline in the share of public deposits and rise in the share of borrowings. In the coming years, the importance of deposits in their sources of funds is expected to decline further. This, however, should not be a cause of concern as in several other countries, borrowings is the main source of funds for NBFCs.

6.163 Reforms have been able to create competition in the insurance sector and give customers a wide choice not only in the matter of insurance companies but also in terms of insurance products. However, impact of increased competition is yet to be felt on the insurance penetration. In the case of mutual funds, although the competition has increased with increase in the number of mutual funds, their growth slowed down sharply in the recent years. This should be a cause of concern as mutual funds in several countries play an important role in the development of the capital market.

6.164 Thus, insofar as intermediaries are concerned, reforms have had a mixed impact. Improvement in the stability and efficiency parameters of the commercial banks has been the major achievement of the reform process. Reforms have also been able to enhance stability of other intermediaries, in general, as reflected in their increased capital position. Reforms have, however, not been so successful in bringing improvement in the efficiency as profitability of some intermediaries such as cooperative banks, NBFCs and DFIs declined in recent years due to various sector-specific reasons. Decline in the asset quality should be a matter of concern as this could also have adverse impact on the capital position of these intermediaries in future. Reforms in future would need to focus on efficiency and soundness of co-operative banks, DFIs and NBFCs.

6.165 The 1990s saw the significant development of various segments of the financial market. At the short end of the spectrum, the money market saw the emergence of a number of new instruments such as CP and CDs and derivative products including FRAs and IRS. Repo operations, which were introduced in the early 1990s and later refined into a Liquidity Adjustment Facility, allow the Reserve Bank to modulate liquidity and transmit interest rate signals to the market on a daily basis. The process of financial market development was buttressed by the evolution of an active government securities market after the Government borrowing programme was put through the auction process in 1992-93. The development of a market for Government paper enabled the Reserve Bank to modulate the monetisation of the fiscal deficit. The foreign exchange market deepened with the opening up of the economy and the institution of a market-based exchange rate regime in the early 1990s. Although there were occasional episodes of volatility in the foreign exchange market, these were swiftly controlled by appropriate policy measures. The capital market also deepened during the 1990s. While the sharp increase in resource mobilisation through equity in the mid-1990s could not be sustained, there was a steady increase in the turnover in the secondary market. In terms of trading and settlement practices, risk management and infrastructure, capital market in India is now comparable to the developed markets. The development of the financial markets was well supported by deregulation of balance sheet restrictions in respect of financial institutions, allowing them to operate across markets. This resulted in increased integration among the various segments of the financial markets.

6.166 Apart from increasing integration of various segments of financial markets, the distinctions between banks and other financial intermediaries are also getting increasingly blurred. Another important aspect of reforms in the financial sector has been the increased participation of financial institutions, especially banks, in the capital market. These factors have led to increased inter-linkages across financial institutions and markets. While increased inter-linkages are expected to lead to increased efficiency in the resource allocation process and the effectiveness of monetary policy, they also increase the risk of contagion from one segment to another with implications for overall financial stability. This would call for appropriate policy responses during times of crisis. Increased inter-linkages also raise the issue of appropriate supervisory framework.

6.167 In India, while the banking system continues to play a predominant role, it is significant to note that, as a result of various reform measures, the relative significance of financial markets has increased. This augurs well for the overall stability of the financial system. The recent East Asian crisis underlined the need for a balanced financial system wherein financial markets also play an important role in providing necessary liquidity, especially during times of crisis. Banking system may also require liquidity in times of stress, which only deep and liquid financial markets can provide.

6.168 Financial sector reforms have supported the transition of the Indian economy to a higher growth path, while significantly improving the stability of the financial system. In comparison of the pre-reform period, the Indian financial system today is more stable and efficient. However, the gains of the past decade have to be consolidated, so that these could be translated to drive the institutions, markets and practices into a mature financial system that can meet the challenges of sustaining India on a higher growth trajectory. The financial system would, therefore, not only need to be stable but would also need to support still higher levels of planned investments by channelling financial resources more efficiently from deficit to surplus sectors. The banks would need to reassess their core banking business to view how best they could undertake maturity transformation to step up the lendable resources in support of real economic activity. Competitive pressures as well as prudential regulatory requirments have made banks risk-averse and their investment in relatively risk-free gilt instruments have far exceeded the stipulated requirements. The behaviour and strategies of bank business would need to change from the present so that they can factor in their own risk assessment even while performing their core activities. There is a need to ensure long-term finance to support development and growth in the economy, even as restructuring takes place through mergers and universal banking. Also, the functioning of the capital markets requires to be toned up so that the levels of primary resource mobilisation seen in the early years of reform period are reached and perhaps surpassed. The key to attaining higher levels of investments by way of direct finance routed through capital markets lie in bringing about institutional improvement. Improved corporate governance practices can go a long way in bringing the retail investors back to capital markets. Institutional reforms supporting risk capital is important in broad-basing the entrepreneurship culture in the economy. While financial sector reforms till date have been helpful, more needs to be done so that greater gains from the financial sector reforms could be realised for the real economy.

6. Although the public issues market for last few years witnessed depressed conditions, corporates were able to mobilises sizeable from the private placement market.
7. Measured as percentage of the value of trade.
8. The allocative efficiency can be tested using a measure of synchronicity of equity prices (calculated as the fraction of stocks traded moving in the same direction). This measure signifies the relative importance of the market-related factors vis-à-vis company-specific factors, and the explanatory power (i.e., the R² measure) of market returns (taken as a proxy for market factors) in a set of individual return generating functions (Roll, 1988; Morck et al, 2000). The allocative efficiency would be higher if investors pay greater attention to company-specific factors rather than market specific factors.