Draft Report of the High Level Group on Services Sector

6.1 Introduction

The importance of the financial sub-sector goes beyond the output and employment it directly generates, given its critical role in enabling broader economic activity, whether in industry, agriculture or other services. The financial sub-sector provides products for mobilizing household and corporate savings, credit for producing and consuming goods and creating long-term assets, transaction banking for facilitating economic activity and insurance for risk mitigation, long-term savings and social security. The perspective of this report is therefore not only the growth of the financial sector, but its effectiveness in its larger role as an agent of economic change. Driven to a significant extent by the liberalization measures of the 1990s, the sector has witnessed robust growth. However, its penetration in India remains low relative to many markets, with bank credit/ GDP at under 50.0%, overall insurance premium/ GDP at under 5.0% and general insurance premium/ GDP at under 1.0%.
In accordance with its mandate the Group examined the different aspects influencing the performance of the financial services sub-sector and with a view to suggesting short-term and long term policy measures to improve and sustain its competitiveness in the coming years. At the outset the Group considered it important to review the status of financial inclusion in India i.e. the extent of access to and utilization of financial services by households and businesses that are geographically dispersed and vary widely in terms of income and other indicators. Studies reveal that despite the policy and regulatory directives towards financial inclusion, 41.0% of the adult population is un-banked. Further, there exists a significant urban-rural divide in the access to banking facilities and credit, with only 39.0% and 9.5% of the adult rural population having bank accounts and loan accounts respectively, as compared with 61.0% and 14.0% in urban areas¹⁴. Clearly, there is a need to rethink our approach to financial inclusion from the prescriptive approach adopted thus far to a more market-based approach that achieves the desired level of penetration in a sustainable manner.
At the opposite end of the spectrum lie the increasingly complex and sophisticated financial services needs of large businesses that are operating in a globalised environment. The ability of the existing Indian financial sector to meet these requirements is constrained by the relatively small size of Indian financial intermediaries that limits their risk-taking capability, regulatory restrictions on products and services that may be offered and the absence of liquid and deep markets in several segments in India.
An analysis of measures needed for the financial sub-sector in India must be centred on enhancing the ability of the financial sub-sector to address this continuum of financial services needs. For sustaining and enhancing the competitiveness of the financial sub-sector the Group was of the view that it was imperative to consider permitting freer foreign participation in the Indian financial sector, and empowering the Indian financial sector participants in general, and the public sector participants in particular, to compete in a globalised environment.
This report seeks to recommend the key measures that taken together would help in meeting the objectives of achieving greater financial inclusion, serving emerging customer needs and enhancing global competitiveness.

6.2 Key reform measures

This section briefly sets out the key recommendations of the Group for reforms required within the existing broad framework of financial sector regulation. There is widespread recognition that the liberalization of the Indian economy has been uneven, with the liberalization of the real sector far outpacing that of the financial sector, as evidenced by the continuing licensing requirements for expansion as well as entry, and the fairly intensive regulation over operational matters. These recommendations thus represent the unfinished agenda of reforms, as well certain specific measures suggested in the context of particular segments.

6.2.1 Banking

The banking sector reforms were carried out during the 1990s based on the recommendations of the Narasimham Committees in 1992 and 1998. Certain key recommendations continue to remain substantially unimplemented. These are set out below:

6. 
   Reduction in regulatory pre-emption: While the Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) have been reduced from the high levels prior to liberalization, the level of regulatory pre-emption of bank liabilities in India continues to be very high relative to other economies. With the moderation in the fiscal deficit and government borrowing requirements, and the overall improvement in the efficiency and health of the financial system since the 1990s, there is a strong case for gradual reduction in SLR in line with other markets. Similarly, CRR which has been increased several times recently as a monetary measure, may be aligned over time with an appropriate globally benchmarked level.
   

7. 
   Phasing out of directed credit: Priority sector lending targets continue to apply to the Indian banking sector. It is observed that the directed agricultural lending targets have not had the desired impact in terms of financial inclusion; banks have often mis-priced credit to achieve the volume targets and have suffered high credit losses. However, a positive development is that banking for the un-banked is increasingly being seen as a growth opportunity by banks. It would therefore be appropriate to move from a mandated directed lending target to a market-based approach, where banks develop sustainable models to engage a wider set of customers in the economic mainstream. Key measures to create a facilitative environment for financial inclusion are set out in Section 3.0.
   

8. 
   Consolidation and increase in scale: The Narasimham Committee had envisaged a move to a banking system with three or four large, international banks; eight to ten national banks with a network of branches throughout the country engaged in “universal” banking; local banks with operations in specific regions; and regional rural banks. However, there has been limited progress in consolidation in the Indian banking system. There are only two Indian banks among the world’s top 100 banks; the largest Indian bank is about one-fifth the size of the largest Chinese bank. The issue of consolidation is particularly relevant for the mid-sized public sector banks that are currently duplicating investments in technology and other infrastructure, and not benefiting from economies of scale. There is an urgent need to catalyse consolidation among these players, and leverage the synergistic benefits. At the same time, the policy environment must favour rapid growth of the banking system to keep pace with economic growth, as well as make Indian banks relevant players in the international arena.
   

9. 
   Abolition of branch licensing: In the context of the overall framework of liberalization of the Indian economy, the requirement of branch licensing may be urgently reviewed as recommended by the Narasimham Committee. It creates challenges in financial inclusion and deeper penetration by constraining the growth of banks. The branch licensing requirement emanates from statute, as well as from regulatory objectives. The key regulatory objectives are to ensure that banks have risk management capabilities commensurate with branch expansion, and achieve financial inclusion through spread of branch infrastructure in under-banked areas. The statutory requirement can be eliminated by amendment to the statute, or an exemption from the licensing requirement under extant provisions. The supervisory objective of ensuring appropriate risk management capabilities can be achieved through the regular inspection and supervisory process. In so far as financial inclusion is concerned, the existing large rural branch network has achieved limited success in this regard, and there is therefore a need for a new approach that recognizes alternative methods of access to financial services. In any event, banks may be required to have a minimum proportion of branches in rural/ semi-urban or under-banked areas, as required by the existing banking license conditions for the new generation private sector banks.
   

10. 
    Reform of ownership and management of public sector banks: Banks majority owned by the government continue to account for about 70.0% of the Indian banking system. The Narasimham Committee had recommended that the minimum government ownership in these banks be reduced to 33%, and the banks should become board-managed companies.
    

In the medium-term, the ability of these banks to raise capital for growth without reducing the government shareholding to less than 51% would be severely constrained. At the same time, infusion of capital by the government would impose fiscal pressures and would be a sub-optimal deployment of the government’s resources, which should be utilized for developmental purposes, while commercial capital is available for the banking sector. It would therefore be appropriate to consider evolution of a path towards reduction of government ownership in a manner that minimizes dislocation or dissonance among various stakeholders. However, as an immediate measure, it is necessary to empower the government-owned banks to address the key competitive challenges that confront them, without altering their public sector character.

Firstly, the oversight of public sector banks by the Central Vigilance Commission (CVC) may be reviewed. This oversight dates back to the nationalization of banks and the pre-liberalisation era when banks essentially allocated credit in line with government guidelines. These banks are now listed entities with non-government minority shareholders; compete with each other and private sector banks to offer credit; and are subject to regulatory supervision and the commercial discipline of the market place. The existence of CVC oversight creates a culture of avoidance and delay in decision-making that seriously damages the banks’ competitive positioning.
Secondly, individual banks should be given the freedom to determine their recruitment, placement, promotion, performance evaluation and compensation policies, including performance bonuses and stock options. These are essential tools in attracting, retaining and leveraging human capital, which is a key competitive differentiator. The uniform pay structure and wage settlement across banks is inconsistent with a competitive market. In this context the regulatory limits and approval requirements for remuneration of bank managements even in the private sector may also be reviewed.
Thirdly, the selection of non-executive board members, the CEO and other executive board members should be determined by the board of directors of each bank. The bank should be free to induct non-executive directors of appropriate experience who would add value to the bank, rather than nominees of government/ minority shareholders. Executive management selection should be based on a robust performance management system to identify the pool of candidates, and should be undertaken by board committees with government/ RBI representative as an invitee, rather than the present practice of the government appointing the CEOs and executive directors of various banks. All appointments must be for a minimum fixed tenure.
The above recommendations would also apply to public sector entities in other financial services segments, such as insurance.