Identifier
Created
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08MUMBAI304
2008-06-26 14:02:00
UNCLASSIFIED
Consulate Mumbai
Cable title:  

INDIAN PLANNING COMMISSION COMMITTEE ON FINANCIAL REFORMS

Tags:  ECON EFIN TRSY IN 
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P 261402Z JUN 08
FM AMCONSUL MUMBAI
TO SECSTATE WASHDC PRIORITY 6383
INFO AMCONSUL CHENNAI PRIORITY 
AMCONSUL KOLKATA PRIORITY 
AMCONSUL MUMBAI PRIORITY 
AMEMBASSY NEW DELHI PRIORITY 
CIA WASHDC
NSC WASHINGTON DC
DEPT OF COMMERCE WASHINGTON DC
DEPT OF TREASURY WASHINGTON DC
UNCLAS MUMBAI 000304 


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E.O. 12958: N/A
TAGS: ECON EFIN TRSY IN
SUBJECT: INDIAN PLANNING COMMISSION COMMITTEE ON FINANCIAL REFORMS
PRESENTS ITS FINDINGS TO MUMBAI'S MARKET PLAYERS

UNCLAS MUMBAI 000304


TREAS PLEASE PASS TO FED AND OCC
SCA PLEASE PASS TO USTR AADLER/CLILIENFELD

E.O. 12958: N/A
TAGS: ECON EFIN TRSY IN
SUBJECT: INDIAN PLANNING COMMISSION COMMITTEE ON FINANCIAL REFORMS
PRESENTS ITS FINDINGS TO MUMBAI'S MARKET PLAYERS


1. Summary: In August 2007, the Planning Commission constituted
a high-level Committee on Financial Sector Reforms (CFSR) to
outline a comprehensive agenda for the evolution of the Indian
financial sector. The Committee compiled its findings and
suggestions in a draft report and put it up for discussion at a
seminar held in Mumbai on June 12. Broadening financial
products and markets, providing greater financial access to the
masses, streamlining regulators, and encouraging financial
literacy were some of the main recommendations of the Committee.
The seminar was divided into five sessions starting with an
overview session followed by detailed discussions on regulation,
financial inclusion, banking and the macro economic framework.
The Committee members had healthy dialogues with the discussants
on each panel - comprising some of India's most prominent
bankers and economists -- as well as answered the questions of
the market participants present at the seminar. Overall, market
participants praised the Committee for its report, though,
predictably, some participants criticized it for going too far,
and others, for not going far enough in recommending broad
market reforms. End Summary.


2. On June 12, Raghuram Rajan, University of Chicago professor
and Chairman of the CFSR introduced the draft report prepared by
the Committee to the financial sector community, in an event
hosted by the State Bank of India (SBI). The Committee was
constituted by the Planning Commission in August 2007 with four
terms of reference: to identify challenges in meeting the
financial needs of the Indian economy and suggest sector reforms
to deal with these challenges; to examine the performance of the
financial sector and list the desirable changes; to identify
changes needed in the regulatory infrastructure to allow the
financial sector to play its role; and to recognize changes in
other areas of the economy that could help the financial sector
function more effectively.


3. Rajan told the audience that "India's financial sector is at
a turning point," and had the potential to grow tremendously
both domestically and internationally, if supported by
appropriate policies. At the same time, he accepted that
deficiencies -- such as inadequate financial inclusion -- could

hinder growth and stability. In explaining the Committee's
report, he said that it was designed with a five to ten year
timeline in mind. It was intended to reflect the comprehensive
views of the Committee's "stellar cast" including market
practitioners, regulators, union representatives, politicians,
academicians and international experts, and was not guided by a
single viewpoint. The report was an outcome of discussions,
dialogue and debates; he added that the feedback received in the
seminar, if accepted, would be incorporated in the final report
to be released on 30th September which would then be presented
to the President of India.


Macro-economic framework


4. Beginning with the report's review of India's macro-economic
framework, Rajan asked how India should adapt the current
framework to the requirements of a dynamic open economy with a
variety of players. First, he said "don't expect the Reserve
Bank of India (RBI) to do magic." Under its current mandate,
the RBI must juggle inflation, the exchange rate, and growth.
He suggested that the RBI would function best by focusing solely
on inflation instead of having multiple and, sometimes
irreconcilable, mandates. An inflation-only focus would lead to
more consistency in policy decisions which would automatically
sustain growth. He stated that no central bank could prevent
supply shocks; central banks tend to tackle the second and third
round effects of inflation. Hence, a focus on inflation control
would prevent "spiral effects." Secondly, Rajan urged the
regulators to open up investment in rupee-denominated corporate
and government bond markets to foreign investors.


5. Adding to Rajan's comments, Committee member Dr. Jayant
Varma, a professor at Indian Institute of Management-Ahmedabad,
criticized the Indian regulator's practice of banning products
and markets, impeding participation from foreign investors, and
imposing excess regulation. He added that markets "may look
like casinos," but were not. Speculators provide liquidity and
are needed in all markets, he said. He also strongly
recommended that the RBI move towards full capital account
liberalization as a longer term reform.


6. Reacting to the Committee's proposal, panel member Dr. D. M.
Nachane, Director of Indira Gandhi Institute of Development
Research (IGIDR),said he "violently disagreed" with the notion
of opening up the capital account. He stated that the marginal
benefit brought about by allowing capital account convertibility
did not outweigh the risks that the economy would face. He
pointed out that the report did not discuss strategies for
moving towards capital account convertibility and added that he
would discuss it in detail in his own research paper, to follow.
Disagreeing with Varma, he said that markets are "casinos driven
by `animal spirits'" and hence cannot be tamed, and that markets
will always remain inefficient.


Financial Inclusion


7. As Rajan stated at the beginning of the seminar, financial
inclusion was very important for the development of the
financial sector. Out of total lending, only 12 percent is from
formal sources like banks, while the remaining is from private
money lenders, he said. The aim would be to eventually get
these lenders into the formal channel. He emphasized that there
were large gaps between the "intention" and "outcome" in
providing access to finance. He also pointed out that credit
was just one aspect; the financial environment needed products
like savings, insurance, investment and pension to broaden the
access to finance. For this, he proposed that both small and
large financial institutions could tackle this problem. In his
view, small, private banks have the advantage of being closer to
the customer and rich with local knowledge which could be used
to penetrate rural and urban communities. He suggested that the
RBI enforce higher capital adequacy norms, more automation and
transparency, and closer supervision, at least in the initial
period to offset the high risk undertaken by the small banks.
For the big banks, he advocated the liberal use of banking
correspondents (BCs) to extend financial services.


8. To aid both the small and big banks, the Committee has
suggested three major actions. The first proposed action is to
offer priority sector loan certificates (PSLC) to entities that
lend to eligible categories in the priority sector and also
allow banks that undershoot their priority sector obligation to
buy the PSLCs. (Note: Domestic and foreign banks operating in
India are required to allocate a part of their net bank credit
to priority sectors like agriculture, small scale industries,
small business, housing, education, etc. End Note.) The second
suggestion is to remove all interest rate caps for priority
sector lending. Instead, he said, banks should be required to
fully disclose the annual effective interest cost of a loan with
the maximum and average interest rates charged. Thirdly, Rajan
recommended improvements in credit infrastructure which would
entail expediting the process of creating a unique national ID
number, sharing credit information more widely, and improving
creditor rights by legislating a bankruptcy code.


9. Sir Thomas Harris, Vice Chairman, Standard Chartered Bank,
criticized the restrictions on foreign banks, arguing that many
foreign banks have tremendous experience and depth and could use
their skills and knowledge to reach out into under banked
communities. He added that the report did not address the issue
of market access for foreign banks. He commented that
investment in microfinance had more than tripled in other
emerging countries, but India had been left behind. Dr.
Nachiket Mor, President of the ICICI Foundation, pleaded that
the Committee promote full banking services in rural areas
rather than just one-product services. Those communities also
need full-fledged services, he added. He acknowledged that
creation of BCs was an interesting idea, as local entities would
be more efficient than large banks. Also he preferred the use
of the extant Permanent Account Number (PAN) system for investor
identification rather than creating a new national ID, as
recommended by the Committee. He suggested "dematerializing"
currency to support the banking infrastructure. Promoting the
use of e-banking facilities would cut down approximately 5-6
percent of the cost which was on account of currency handling
and transportation, he added.


Leveling the Playing Field


10. Rajan noted that public sector banks (PSBs) are reasonably
profitable, but are falling behind due to their lack of new
market segments and products, talent, and the innumerable
constraints on automation and risk taking. He asserted that
through efforts to "protect" the PSBs, regulators are actually
stunting their growth. In order to increase competition and
efficiency, he recommended creating stronger boards for large
PSBs giving more power to outside shareholders, or possibly a
strategic investor. He urged the Indian government to reduce
its oversight and suggested privatizing small underperforming
PSBs to gain useful experience from the process. Allowing banks
to set up branches and ATMs anywhere and being more liberal in
allowing takeovers and mergers, especially for domestically
incorporated subsidiaries of foreign banks, were the other
reforms suggested by the Committee.


11. Deepak Parekh, Chairman, HDFC, agreed with Rajan that PSBs
were constrained, especially in regards to capital. He noted
that customers were demanding more from the financial sector and
the need of the hour was "a small number of large banks and not
a large number of small banks." He also recommended assigning
timelines on the recommendation of the Committee, in hopes that
this would force the government and regulators to implements its
recommendations in a timely manner. O.P. Bhatt, Chairman of the
State Bank of India (SBI) and also one of the Committee members,
commented that the Indian government, as in case with most
governments, often only undertook innovation in times of crisis,
and now was the "perfect time" for the release of the report.
He also pointed out that the report had found guidance from
different reports but still managed to produce a unique product.
On the issue of PSBs, he quoted a report by the credit rating
agency Moody's indicating that PSBs were losing around 1 percent
market share per annum on average for over 15 years to the
private sector. Currently in terms of total assets, the PSBs
have a 70 percent market share. "Hence it would take 70 years
for them to wipe us away", he joked. He said that "earlier
there was only one bank- the RBI -- and others were just
outlets." In that time, the RBI made all decisions, and the
banks were only administrators of RBI policies. Now, however,
despite a fair amount of liberalization, PSBs still find it
difficult to meet customer demands. PSBs were willing to change
but the environment didn't support those changes. He was happy
that the Committee had recognized this fact and hence was
suggesting "evolution" and not a "revolution."


The Creation of more efficient and liquid markets


12. Rajan explained that the Committee listed numerous reforms
needed to support the enormous financing, investment and hedging
needs of the "new" economy. The report recommends bringing all
regulation under the Securities and Exchange Board of India
(SEBI) and allowing the financial sector to experiment -
cautiously - with new products and markets. To promote greater
participation in domestic markets, the Committee wanted to see
more and broader foreign participation and entry of transparent
products for the poor.


13. K.V. Kamath, Managing Director and CEO of ICICI Bank and
also a member of the Committee, remarked that every word was
carefully weighed before putting it down in the draft. He also
acknowledged that open markets were critical in ensuring that
the financial sector kept pace with India's growth, especially
when the nation was growing at 8-10 percent. Sanjay Nayar, CEO
Citigroup India, however, expressed his skepticism that the
recommendations of the report would be implemented. He
highlighted the issue of access to funds, saying that only a
AAA-rated project would be able to find long-term financing in
India. It was very difficult for start-ups to find financial
backing. In addition, the volatility in India's most liquid
markets is higher in comparison to other developing countries.
Consequently, he agreed with the Committee's recommendation to
focus on the development of debt and derivatives market to hedge
this volatility more efficiently.


A growth-friendly regulatory environment


14. Rajan highlighted the fact that India, so far, had not
suffered from the recent financial crises. However in fear of
being affected by crises, he denounced the excessive
micromanagement of the economy by the regulator, and hoped that
the regulator would not "govern the leaves instead of the
forest". He appealed to create a transparent process of
evaluating performance -- rather than adherence to rules -- and
rewrite financial sector regulation. He also laid down
guidelines to tackle regulatory gaps and co-ordination. He
proposed setting up a Financial Sector Oversight Agency (FSOA)
whose role would be purely to monitor and supervise the
functioning of large, systemically important financial
conglomerates, address inter-regulatory conflicts and look out
for the build-up of systemic risks. He also promoted the
development of the Office of Financial Ombudsman to spread
literacy and counseling among the masses and a Financial
Development Council to be headed by the Finance Minister to
implement structural reforms in the financial sector.


15. With regards to issues of micromanagement, P.K. Nagpal,
Executive Director, SEBI, did not agree with the Rajan report.
He insisted on amending the paragraph on micromanagement in the
report. He maintained that SEBI followed both principle and
rule based regulation with investor protection, development and
protection of security markets being the main objectives. He
added that they were setting up a National Institute of Security
Markets to promote investor education. O.P. Bhatt stated that
the report does not recommend going so far as to prompt a
crisis. For example, he said that India has only about 20,000
ATMs, but the country needs close to 100,000, the PSBs were
starved of capital, and Indian banks lacked sound risk
management practices. Deepak Parekh added that in any financial
system, there were bound to be bubbles. While the Indian
financial system was sound, an efficient regulator had to
anticipate the bubbles and take appropriate steps to avoid a
crisis situation. Rajan clarified that the report was a pathway
to take us forward. It was not a map taking us where other
financial markets were.


16. Comment. The Rajan report, instead of focusing on a few
large and controversial steps, as some reports before it have,
lays down numerous small steps that will collectively help to
develop the next generation of reforms for the Indian financial
sector. The report strives to build a bridge between the
capacities-capabilities of the financial sector and needs of the
real economy. It recommends including more Indians to foster
growth and building up financial stability by bringing the
regulator under the scanner. The report looks at the multiplier
effect of the developments of the Indian financial environment
in contributing to the economic growth rate. Overall, these are
sound recommendations, though many feel they are not enough.
However, since the decision to move forward with banking and
financial sector reforms is largely political, rather than
economic, in nature, small steps may be the best approach for
the current environment. End Comment.

OWEN