Financial Sector ReformsTheory and Measures

Dr. Prabhakaran Nair V.RLecturer

Department of EconomicsSD College

• Features of Financial Markets• What is information asymmetry?• What is financial repression?• Financial Sector Reforms

Features of Financial Markets

• Economics is concerned with?– Commodities

Goods-Rice and cars

Services- transportation and labour

Assets-land, machines

- Money as dollars and rupees is not a commodity but means of exchange of commodities

-Securities such as bonds and stocks are neither commodities nor money but contracts for the exchange of commodities or money.

• Financial economics-specialised branch of economics

• Securities or financial products are different from commodities and money

• Financial products are contracts that allow investors to delegate the management of their assets to others, eg. Mutual fund or unit trust where investors retain full legal title to their asets.

• In the case of equity, debt, and bank-mediated instruments, investors surrender their assets in return that constrain managers and directors

• They have to pay dividend and interest payments.

When Market allocate resources efficiently?• According to Arrow and Debreu:

1. There is full information

2. Agents are atomistic – too small to influence prices

3. There are no externalities – unpriced side effects eg: environmental pollution

Then agents will have the same piece of information – this result in prices that fully reflect the values of the goods transacted

However, the moment this information is private – i.e., it is accessible to individual or some of their close associates.

Individuals have an incentive to hide their information from the rest of the market to make gains.

Eg: in the market for insurance, clients will typically know more about their own risk characteristics and have an incentive to hide this so that they are asked to pay smaller premiums on their insurance policy.

Asymmetric Information• A situation in which one side of the market knows more

about the properties of the good being traded than the other• This results in inefficient trading or no trading at all• The essential feature of a financial market is the existence of

information asymmetry– Every one does not have access to the information-it is

not exogenous– Public information is endogenous – we can improve this

information through research via screening, monitoring or auditing activity

– However, information generated is a public good– So there will be little incentive for spending private

resources to acquire information that becomes publicly available

Approaches of Information Asymmetry

• Moral hazard:

• situation, where the action of firms is unobservable or where the investors have no control over the action of agents.

• It occurs when a contract changes the incentives and behaviour of the parties

• Hidden actions during the period of the contract

• For eg. In an insurance contract-the outcome of a car crash depends on the behaviour (rash driving) or chance – it is difficult to know which factor prevailed

• In corporate finance, moral hazard is related to end use of funds

• after a loan is given, the borrower may take actions that reduce the probability of repayment

Adverse selection:

• Arises due to hidden information• For eg: firms have private information but they do not fully

dispense it with while entering in to contract (issuing equity). • In a second car market, the seller knows more about whether

the car runs smoothly and reliable than does the buyer• In order to avoid adverse selection problem, investors would

try to minimize information disadvantage by utilizing available information.

• Use screening devices, eg: In insurance, clients are subject to a check-up by a doctor

• Banks use information systems to identify clients with poor credit records

• Stock brokers employ company analysts to tell them about financial health of companies

Impact of Asymmetric InformationCredit Rationing:

1. Among loan applicants who appear to be identical, some receive a loan and others do not.

2. The rejected applicants would not receive a loan even if they offered to pay a higher interest rate.

3. There are identifiable groups of individuals in the population who, with a given supply of credit, are unable to obtain loans at any interest rate, even though with a larger supply of credit.

4. Another form of rationing is that banks make the provision of credit in later periods contingent on performance in earlier period; banks may then refuse to lend even when these later period projects stochastically dominate earlier projects, which are financed.

• Credit rationing will disturb the balance between supply and demand for funds.

• In a credit market the interest rate charged on the loan, is different from the expected return to lenders.

• Because, the expected returns to banks also depends on the repayment probability of borrowers.

• The interest rate affects this repayment probability of borrowers and, hence, the expected return to banks through adverse selection and moral hazard (adverse incentive).

• In the credit market adverse selection means, due to asymmetric information, lenders may select risky borrowers, the “lemons”.

• Moral hazard refers to a situation where, after a loan is given, the borrower may take actions that reduce the probability of repayment.

• “Lemons” problem arises from the fact that the buyer of a used good does not have the same information about the quality of the good as the seller does, so the buyer is willing to pay only an average price for it.

• The owners of the above average quality goods will then leave the market because the average price is too low for them.

• This leaves the market with a supply of only less than average quality goods, which are called “lemons”.

Effects of an increase in interest rates

1. First, there is a direct effect that as interest rates rise, the expected return to the bank increases, if other things remain the same.

2. Second, there will be an adverse selection effect that if a lender raises interest rates, the pool of applicants increasingly

contains high return, high-risk projects. This is because those borrowers who are willing to pay high interest rates usually have high return, high-risk projects, and borrowers with low return, low risk projects will drop out of the applicant pool because they may be unable and/or unwilling to pay high interest rates. This result in a pool, having only applicants with lower repayment probability and thus, the expected return to the bank declines as interest rate

rise.

• Informational asymmetries may introduce inefficiencies in financial markets that make external funds more costly than internal funds.

• Then firms have to follow a hierarchy in which cheaper funds are preferable to more expensive ones and internal funds are the most preferable ones.(Pecking order theory).

• Thus to improve, the allocation of resources, financial intermediaries are needed to reduce market imperfections.

• It is in this respect financial liberalisation has been recommeneded.

Financial Repression in India

• The financial system has evolved in an environment of administered interest rates and maintaining stipulations on credit distribution.

• Government of India determined the quantum, allocation and price of credit, a situation referred to as ‘financial repression’ in the financial system.

• Government used to finance expenditure in excess of tax revenue by forcing the private sector to buy government securities at rates below the market rates of interest.

• For eg: insurance companies and pension funds are often required to hold larger proportions of assets in the form of government securities

• Government also imposed highstatutory liquidity ratio (SLR) of the banking system. – High casjh reserve ratio (CRR)

• Government set ceilings on institutional interest rates to prevent competition from the private sector

• low productivity and inefficiency, which in turn led to low/negative profits

• high level of non-performing assets • quantitative credit restrictions,

concessional interest rates for specified sectors along with cross-subsidisation

• Restrictions on international financial transanctions.

• Mc-Kinnon and Shaw (1983) argued that government controls involves distortions of interest rates in which higher rates of interest reduces the size of the financial system and thereby growth rate of the economy.

• Saving is a positive function of the rate of interest

• Real rate of interest

• Investment is a negative function of interest rate

• Higher the interest rates lower the profitability of investment projects and reduce the investment expenditure

Under financial repression credit is not according to the expected productivity, but according to transactions costs and perceived risk of default.

Quality of collateral, political pressures, name, loan size, covert benefits to loan officers influence allocation.

• Financial Repression in the form of regulated interest rates and directed credit programmes led to inefficiencies in credit allocation

• According to McKinnon and Shaw –the policy prescription is to raise the institutional rates of interest according to market levels.

• It also helps to avoid undertaking low-yielding investment projects since they are no longer profitable at the higher interest rate.

Financial Reforms and Sources of Financing • recommendations by the Narasimham Committee

appointed by the GoI.• Financial sector liberalisation has shifted the focus of

financial repression, from the ‘control of financial products prices’ to prudential regulation, supervision and promotion of competituion

• deregulation of capital markets and banks,• deregulation of interest rates, • withdrawal of credit targeting and interest subsidies,• introduction of stricter accounting norms in the

banking sector and • the integration of domestic financial markets with the

international financial markets

Reduction in Reserve requirements or pre-emptions

Table 2.1: Movements in Monetary Instruments

Year CRR SLR Bank Rate 1991-92 15 38.5 10 1992-93 15 38.5 12 1993-94 15 37.25 12 1994-95 14 34.75 12 1995-96 15 33.75 12 1996-97 14 33.75 12 1997-98 10 33.75 9 1998-99 9.50 25 8 1999-00 9 25 7 2000-01 5 25 6.5 2001-02 4.75 25 6.25 2002-03 4.50 25 6 2003-04 4.75 25 6

Source: Reserve Bank of India, Hand Book of Statistics on Indian Economy, 2005-06. Note: CRR: Cash Reserve Ratio; SLR: Statutory Liquidity Ratio.

Table 2.2: Lending Rates of Commercial and Term Lending Institutions

Saving Deposit Rates

Year 1 to 3 year

3-5 Years

Over 5 Years

Deposit Rate (1 Year)

(% per annum)

Ceiling or Minimum Loan

rate (% per annum

SBI Advance

Rate IDBI

1990-91 9.5 11 11 9 16 16.5 14.5 1991-92 12 13 13 12 19 16.5 19 1992-93 11 11 11 13 19 19 18 1993-94 10 10 10 10 17 19 16 1994-95 11 11 11 <10 14 15 15 1995-96 12 13 13 <12 Free 16.5 17.5 1996-97 11.5 12.5 12.75 Free Free 14.5 16.2 1997-98 10.75 11.75 11.75 Free Free 14 13.3 1998-99 10 11 11 Free Free 13 13.5 1999-00 9 10.25 10.25 Free Free 12 15.4 2000-01 8.75 9.75 9.75 Free Free 11.5 14 2001-02 8.25 8.68 8.63 Free Free 11.5 11.5 2002-03 5.13 5.875 5.875 Free Free 10.75 10.2 2003-04 5.37 5.375 5.375 Free Free 10.25 8.90 2004-05 6.25 6.00 6.00 Free Free 10.25 NA*

Source: Reserve Bank of India, Handbook of Statistics on Indian Economy, 2005-2006.

Prudential Reforms and Institutional Strengthening • internationally accepted prudential norms relating to

income recognition, asset classification• provisioning for bad and doubtful debts and capital

adequacy norms • Protection against the risk of insolvency in terms of

capital• It is the extent of a financial institution’s owners’ equity

stake in the financial institution as measured by the difference between the market value of its assets and liabilities (net worth)

• Capital adequacy norms are intended to protect a financial institution to absorb unanticipated losses.

• The higher the amount of capital the more protected are uninsured depositors in the event of liquidation of the institution.

Provisioning for NPAs• Banks have now been given a clear definition of what

constitutes a ‘non-performing’ asset • The definition of ‘non-performing’ asset is also being

tightened over a time. • Banks are now required to make provisions on advances

depending on four types of classification viz., – standard assets: repayment regular– sub-standard assets: This refers to cases where the current

networth of a borrower is not enough to ensure recovery of dues to the bank in full. Eg: NPA for a period less than one year

– doubtful assets: Sub standard + collection is highly questionable and improbable- substandard asset 12 months

– loss assets: los has been identified by the bank but the amount has not been written off wholly- uncollectable

Income Recognition NormsNorms that recognise income on assets only

if it is received within a specified period after it is past due

The International norm is 90 days

Objective is to keep the confidence of the public from eroding due to balance sheet impact

Income recognition is based on the record of recovery

Capital Market LiberalisationIn India, capital market reforms started in 1992 when SEBI was

vested with statutory powers to regulate the capital markets

SEBI introduced new reforms in the primary market for improving the disclosure standards, introducing prudential norms and simplifying issue procedures.

The abolition of Controller of Capital issues (CCI) in May 1992

Market capitalization is the share price times the number of shares outstanding .

Turn over ratio is the total value of shares traded during the period divided by the average market capitalization for the period.

Average market capitalization is calculated as the average of the end of period values for the current period and the previous period.

Table 2 3: Trends in Stock Market Development Indicators

Year Market Capitalisation Ratio Turn Over Ratio Value Traded Ratio 1990-91 13.4 6.0 - 1991-92 16.0 6.3 - 1992-93 25.1 24.3 6.1 1993-94 42.8 23 9.8 1994-95 46.3 14.5 6.7 1995-96 47.5 8.9 4.2 196-97 36.9 24.6 9.1 1997-98 41.4 32.9 13.2 1998-99 35.6 50.2 17.8 1999-00 47.1 75.2 35.4 2000-01 27.4 17.5 47.9 2001-02 26.9 50.2 13.5 2002-03 23.2 54.9 12.7 2003-04 43.5 41.9 18.2 Source: Reserve Bank of India, Hand Book of Statistics on Indian Economy, 2005-2006.

Funds through Foreign Investment

• In 1993, capital markets were opened for foreign institutional investors (FIIs)

• Allowed Indian companies to raise capital abroad by issue of equity in the form of Global Depository Receipts (GDRs).

• Foreign Currency Convertible Bonds (FCCBs).