I. Pre- reform Financial System in India and Rationale for Reforms The Indian financial sector today is significantly different from what it used to be a few decades back, in the 1970s and 1980s. The Indian financial system of the pre-reform period essentially catered to the needs of planned development in a mixed-economy framework where the Government sector had a predominant role in economic activity. Fiscal activism to kick start economic growth took the form of large developmental expenditures by the public sector, much of it to finance long-gestation projects requiring long-term finance (Reddy, 2000). This necessitated large borrowings by the Government and to facilitate the large borrowing requirements of the Government, interest rates on Government securities were artificially pegged at low levels, quite unrelated to market conditions. The accommodative fiscal stance had to be supported by issuances of ad hoc treasury bills (issued on tap at 4.6 per cent) leading to high levels of monetisation of fiscal deficit during the major part of the eighties. In order to check the monetary effects of such large-scale monetisation, the cash reserve ratio (CRR) was increased frequently to control liquidity. Thus, the financial sector prior to the 1990s was characterised by various features as detailed below.
First, financial markets were segmented and underdeveloped coupled with paucity of instruments. Second, there existed a complex structure of interest rates arising from economic and social concerns of providing directed and concessional credit to certain sectors, ensuing “cross subsidization” among borrowers. To maintain spreads of banking sector, regulation of both deposit and lending were effected. This resulted not only in distorting the interest rate mechanism, but also adversely affected the viability and profitability of banks. The lack of recognition of the importance of transparency, accountability and prudential norms in the operations of the banking system led also to a rising burden of non-performing assets. As Reddy (2000) has observed, there was a de facto joint family balance sheet of Government, RBI and commercial banks, with transactions between the three segments being governed by plan priorities rather than sound principles of financing. 3
The policies pursued did have many benefits, though such benefits came at a higher cost. The phase was characterised by significant branch expansion to mobilise savings and there was a visible increase in the flow of bank credit to important sectors like agriculture, small-scale industries, and exports. However, these achievements co-existed with emergence of macro-economic imbalances such as the persistent fiscal deficit and inefficient functioning of the financial sector. Excessive concentration of financial resources was contained to a significant extent. Importantly, there was no major episode of failure of financial intermediaries in this period.
Thus, the phase starting with nationalisation of Indian banks in 1969 till the 1990s, the state of the financial sector in India resembled the classic case of “financial repression” as propounded by MacKinnon and Shaw ( Mohan, 2004a). The sector was characterised, inter alia, by administered interest rates, large pre-emption of resources by the State and extensive micro-regulations directing the major portion of the flow of funds to and from financial sector. The regulatory regime prior to the 1990s thus led to: (i) inefficiencies in the financial system; (ii) underdeveloped financial markets serving as a captive market for resource requirement by the State; iii) limited product choice in all segments of the financial market; iv) low level of liquidity in the securities market with new equity issues governed by extensive regulations, pre-emption of resources in Government debt market to fulfil high statutory reserve requirements and...