R A

Dear Sir,
Draft Report of Committee on Financial Sector Reforms (CFSR) provides a comprehensive and valuable basis for debate on various structural issues relating with Indian Financial Sector.
As mentioned in 'Acknowledgements' by Dr. Raghuram G. Rajan (Chairman), report outlines an overall view, highlighting the links between various needed reforms, and offers many insightful approach for evolution of Indian Financial Sector in coming years.
Guided by the analytical discussion presented in the report, I take opportunity to share some of my observations on topical issues, which may be relevant to effective functioning of specific areas of Indian financial sector.

1. Market Infrastructure and Regulatory Framework
The report has highlighted on increased costs and operational overheads, reduced market efficiency and liquidity resulted from segmentation of financial markets. It has also emphasised on the constraints of regulatory architecture operating in 'silo model'.
On the market infrastructure front, apart from trading in financial instruments (equity/bond/ interest rate/currency/derivatives) and commodities, market has recently witnessed new announcements about development of Power Exchanges and trading in Certified Emission reduction (CER)/ Carbon Contracts.
Regulatory supervision of power trading exchanges is vested with Central Electricity Regulatory Commission (CERC). Subsequent to issuance of guidelines for setting up of Power Exchange by CERC in February 2007, there are announcements about 3 operator groups planning to launch different platform for trading in electricity.
Recently launched trading on CER on commodity exchanges follows completely different transaction life cycle than typical commodities. India being the net seller of CER to international buyers, sound regulatory framework on trading, clearing and settlement aspects needs to be established. It is to be noted that National CDM Authority in India presently conducts review of project proposals and issuance of CER credits. However, to provide a comprehensive framework on these aspects, a close coordination between FMC and CDMA would be needed.
While characteristics of market participants in trading of these products would be completely different than participants in financial markets, from integrated market infrastructure and regulatory framework perspective, these aspects may require closer assessment.

2. Financial Literacy as a key tool to Financial Inclusion
Report in respective sections has highlighted on the significance of Financial Literacy as a key tool to Financial Inclusion of vulnerable sections. Proposal for an integrated ombudsman to enhance financial literacy and financial counselling is much-required step to fulfil challenging requirements.
It has been observed that many initiatives by SEBI, RBI, DCA, individual banks and other institutions have been initiated in recent years. However, these are greatly fragmented, targeted on narrow focused subjects with less effective delivery tools. Delivered mostly in the form of meeting checklist criteria, outcome of these initiatives on the ground does not present highly encouraging picture.
Proposal on a single institution with a mandate to propagate comprehensive education on financial matters (Household savings and budgeting, Retail banking, Insurance, Securities market, Housing Loan, Credit Card, Investment products, Pension and Retirement security) would be highly effective step in achieving the desired goals of universal financial literacy. Funded with investor protection fund/ government grants, the institution would carry-out structured literacy program, workshop, seminar and survey through formal/informal delivery channels across the country.

3. Identity Infrastructure
While several ongoing initiatives on Identity has been discussed in the report, with increasingly growing volume of internet banking, internet trading and other form of e-commerce transactions, it would be imperative to consider development of common identity authentication infrastructure supported by the government and industry.
Amongst the many available options, Biometrics unquestionably provides highly secured and robust credential to establish identify and validation needed for financial transactions. However, challenge associated with biometrics is that it would require establishment of central shared repository of biometrics samples with common standards of industry wide applications and interoperable algorithm/ templates.
To meet higher costs involved, it would require a high level of collaboration between government and industry to develop on common Identity authentication infrastructure on cost sharing basis. Delivered from single infrastructure, it would serve the dual purpose - of supporting many of governmental identity requirements as well as basis of authentication in financial transactions.
Considering huge challenges of Identity Management afflicting the financial sector, more particularly with rising incidences of identity theft and phising, suitable policy enforcement by government and industry initiatives to develop a shared identity infrastructure would be a logical step.

4. Financial Intelligence
Financial Intelligence Unit has been set-up under Department of Revenue (Ministry of Finance) in 2004. Apart from receiving, processing, analyzing and disseminating information on suspected financial transactions, it is responsible for coordinating strengthening efforts of national and international intelligence, investigation and enforcement agencies in pursuing the global efforts against money laundering and related crimes.
It is noted that much of the focus of Financial Intelligence at present remains around Anti-Money laundering and Combating Financing of Terrorism. Most of the systemic frauds, scams and white-collar crimes in financial sector remain mostly out of purview from any effective preventive surveillance.
As per recently published India Fraud Survey Report 2008 by KPMG, Financial services sector was considered relatively more susceptible to fraud followed by real estate/infrastructure and IT/ITes.
Without much emphasis, such fraud activities cost much to business, regulators and government alike. Many times, ordinary people are defrauded of their hard earned money through organised mechanisation, which badly affects public confidence in overall effectiveness of governance of financial system.
It is necessary that suitable consideration is made on developing a framework to deal with aspects of fraud and white-collar crime in financial sector.

5. Promotion of Mutual Fund as preferred Investment Vehicle
As per 2007 Investment Company Fact Book published by Investment Company Institute (USA), nearly half of all U.S. households owned mutual funds in 2006. Individual investors and household investors with divergent financial goals hold around 87 percent of total mutual fund assets.
Unlike US, where mutual funds are considered as long-term investment vehicle by individual investors, the Indian mutual fund market is extremely short-term in nature with dominant presence of non-retail investors. As highlighted in Cadagon report on Mutual Fund reforms In India, "short term" can mean up to a couple of weeks, "medium term" up to six months and anything over six month can be construed as "long term".
Mutual fund industry should work primarily to provide investment vehicle to retail investors. However, this idea has been greatly diluted due to rampant abuses caused by AMC on the issues of fund governance, investment decision and operation. In order to maximize their management fees, AMC allows corporate to exploit larger benefits (at the expense of other investors) by making shot term investment in a given fund. Large presence of corporate investment with sudden withdrawals and investments many a times creates large instability not just for the involved funds but the industry as a whole. After losing the confidence in governance and operation of fund companies, retail investors shy away to further make any investment in mutual funds.
In this context, it would not be bad idea to bar short-term corporate investment in mutual fund companies altogether, which is primarily used for tax advantage/avoidance.
Many times, retail investor expects regulatory intervention simply for the reason that market conditions are falling or funds are underperforming. This further emphasises on importance of investor awareness and education in Indian situation about risks and challenges associated with a particular investment vehicle.

6. Regulator of Regulators
Proposal on Financial Sector Oversight Agency (FSOA) to develop a supervisory layer with a view to coordinate amongst regulators in the area of regulatory gap/overlap and functioning of large systematically important financial conglomerates, in principle presents an appropriate measure to achieve coordination on market-wide issues spanning across regulators.
However, despite its proclaimed intentions, it is likely to result into adding another layer of regulatory burden and in all possibility opportunities of intra-regulatory conflicts. Further, within the ambit of specific regulatory domain, identification of financial conglomerates may appear misleading unless specific regulated activities of any such conglomerate are considered and analyzed to draw the cross-market/systemic impacts.
The ideal option would be to minimize the regulatory gaps/ overlap by effectively rationalizing and enhancing the regulatory area under span of each involved regulator. Thus, each regulator would be able to take full responsibilities for area under its jurisdiction without much conflict and overlap.
To achieve coordination and information sharing amongst regulators on market wide issues, cooperation and communication at operational level requires to be greatly fostered. Further, idea of cross board membership as a mean to communication and coordination would certainly achieve a lot, without establishment of FSOA as an apex umbrella organization.
I trust, above observations brings some useful perspectives on the discussion. In case of any query/clarification, I would be glad to provide further information.

Thanking you,
Yours sincerely
IP C

Dear Sir,

I glanced though the Report and in the section on DICGC information on premium payment needs to be updated. ‘DICGC does not distinguish between the soundness of different banks and charges a flat insurance premium of 0.05% for all Banks’.

This should read as ‘a flat insurance premium of 0.10 % ( revised since 1/4/2005, Annual report, DICGC 2006-07)web-site www.dicgc.org.in

R.K.

Dear Sir,

This lucid and scholarly report is interesting. However, like earlier reports of different expert committees on financial sector reforms, the report suffers from tunnel-view syndrome of looking at bank credit channels as it does not discusses the systemic problems arising out of weaknesses in non-bank credit channels. It is strongly felt that systemic disruptions in the post-1997 in non-bank credit channels is having serious impact on the financial system and its credit creation and credit absorption capacity seriously. An unique and non-conventional approach of integrated analysis of both bank credit channels and non- bank credit channels in understanding of financial sector is presented below :

Dr. Raghuram Rajan CommiitteeReport mainly concentrates on bank credit channels (BC) consisting of banks and financial institutions whereas non-bank credit channels (NBC) consisting of heterogeneous entities such as trade creditors, NBFCs, indigenous money lenders, company deposits, finance firms, etc. which are indispensable part of financial intermediation process are not dealt. Financial sector reform framework must take into account that a large volume of credit is created outside the banking system through trade credit channels. A very high proportion of saving, investment and credit in our economy is channelised through NBC. It provides critical links in the whole credit chain. Its size, reach and network are stupendous. Over the years, it has greatly contributed to the development of trade and industry in the country. McKinsey Report " Accelerating India's growth through financial system reform" May 2006 says that banking sector intermediates only half of the country's total savings and investment. Confining deliberations to BC by different expert committees, policy makers and academicians and the resultant financial policy framework misses the bigger and real picture. This leads to low efficiency and efficacy of various measures taken to strengthen the intermediary role of BC and credit absorption capacity of the economy. Over the years FDI/FII flows, stock of FDI and accumulated foreign exchange reserves of India are quite low compared to China, but it has not created the level of problems in utilisation/management of these surpluses for China as compared to India. The bank credit to GDP ratio in the country is also low compared to many asian countries. This shows that financial sector reforms since 1990s were incomplete and less effective. It is mainly due to disruptions in credit creation capacity of NBC since FY 1997-98.

Linkages between BC and NBC: Financing economic operations is a complex and multi-channel activity. Funds from different sources form an integrated financial base of a firm. Strong linkages between BC and NBC typically take the form of significant and seamless flow of funds between the two sectors as credit from different sources form an intricate, interdependent and mutually supportive chain relationships in an economy. They provide crucial links in the credit chain and credit-multiplier process. Bank credit ultimately travels through NBC. Any serious analysis of macro-financial policy in the country must take into account the existence of NBC as well as its other structural features that distinguishes the country from the text-book industrial country case. Looking at credit flows from BC only and failure to integrate NBC into the macro-economic and financial sector policies framework have resulted in incomplete/misleading diagnosis of economic problems and policy advice. This is amply evident when in the post-1997 period, the economy suffered slowdown basically due to negative developments in NBC. A brief outline of crisis in NBC and spurt in financial sickness is outlined in Appendix1. A large number of businesses experienced financial sickness. There was a rapid decline in the fortunes of financial world's icons like IDBI, UTI, IFCI etc, virtual bankruptcies faced by State Financial Corporations (SFCs), decline in fortunes of Urban Cooperative Banks (UCBs), spurt in NPAs and multiple increase in BIFR cases. The drastic and rapid decline of these institutions, rise in NPAs of banks, steady fall in banks' credit deposit ratio and industrial slowdown during 1997-2002 period was not due to any radical changes in financial market policy framework relating to BC nor any drastic changes in the working of the economy. It is felt that industrial slowdown, marked changes in credit flow and fundamental shift in credit risk perception in the financial system are the after-effects of systemic disruptions triggered by rapid and en-masse meltdown of NBFCs in FY 1998. This was compounded by a string of coinciding developments which included fall in company deposits following tightening of regulation and negative public perception, disruptions in ICD market, outflow of fund from informal channels under VDIS Scheme, 1997, downturn in equity issues, funds stuck in unfinished projects started after liberalisation, east-Asian crisis in 1997, stringency in availability of institutional credit etc. These systemic disruptions along with decadence in credit culture and weak creditors’ rights have led to strong preference for cash-and carry business transactions. High cash discounts reinforces this . This reduces demand for credit. These explain low demand for business credit from banks as ultimately bank credit passes though NBC channels. Impact of these developments was severe on trade credit. A brief note on importance and disruptions in trade credit is given in Appendix2.

Crisis of trust and confidence in trade credit channels is contributed by rapidly vanishing social/business stigma against wilfull default/delay in repayments of trade credits. The fear for default is eroded. No more majority of people feel ashamed/morally guilty of being defaulters. These have eroded confidence in credit creation and have undermined the very ethical basis upon which the economic society stands. These fundamental shifts in NBC has not been recognised/analysed. Weaknesses in NBC has generated crucial vulnerabilities and imbalances in both financial sector and real economy. Cumulative effects of turbulence in NBC seriously disturbed the systemic convergence among the various financial intermediaries. A strong and widespread preference for cash-based transactions vs. credit-based transactions have redefned the rules of business transactions and demand -supply scenerio of business credit . Systemic disturbances and uncertainty in any credit channel increases credit risk for other credit channels and may result in sub-optimal credit market equilibrium. It has disturbed the systemic convergence among the different financial intermediaries. Uneven flow of financial resources is causing cumulative imbalances and infirmities of systemic nature both in the financial and real economy which inter alia includes:

• Steady decline in the share of industry in non-food bank credit from about 55% in mid-1990s to 39% in FY 2006 and FY 2007. At the end of FY 2001 the proportionate share of FIs in total credit flow to industry form FIs and banks was about 40%. With IDBI and ICICI becoming banks and very little or no flow of industrial credit from IFCI, IRBI, SFCs, State Industrial Development Corporations, it is assumed that credit demand from these FIs is transferred/reflected in the banks' industrial credit portfolio. To compare the share of industry credit of banks in mid-1990s and FY 2007, if we remove the proportionate share of FIs at about 40% (as obtained in FY 2001) from bank credit to industry in FY 2007, the share of industry in non-food bank credit comes to about 28 which is just half of its share in mid-1990s. Further, in this industrial credit the share of bank credit to infrastructure has grown from about 4 % in 1996-98 period to 20.5% in FY 2007. If infrastructure credit is taken out from bank industrial credit as generally these were earlier funded by budgetary allocation, there is further decline in the share of bank credit to manufacturing sector to about 18% in FY2007. CAGR of manufacturing sector during FY 1997-06 period was 7.1% as compared to 7.3% during FY 1991-98 period. The kind of credit expansion needed to spur higher industrial growth is not happening.

This fact of declining share of bank credit to industry is well reflected in a paper Economic Reforms and Corporate Performance" by Shri Rakesh Mohan, Deputy Governor, RBI. It shows secular decline in DER, current ratio, debts to sales, working capital (current assets - current liabilities) to sales ratios of manufacturing companies since mid-1990s. The same trend is reflected in CMIE's data on companies financials relating to manufacturing sector. Falling average debtor days, total borrowings to sales and negative current ratio in respect of some of blue-chip companies imply less borrowings and less trade credit sales. Loss of trust and confidence in intra and inter trade credit is resulting into more cash-based transactions. This reduces both purchasing and selling capacity of a businesses and thereby flow of transactions. Further, the cash discounts on an average ranges from 3% to 5% across industries which imply abnormal annual return of 36% to 60% on working capital. It implies that firms with strong working capital/cash-in-hand can benefit from high discounts. This makes trading more profitable than investment in manufacturing. This may be inducing many corporate houses to go whole hog for retail business. Distortions in TC affect SMEs more adversely. Its impact on the new and growing enterprises with less credit reputation is even more serious. This is the main reason for drastic decline in setting up of green-field projects by first generation entrepreneurs as TC is essential for survival and growth of an upcoming enterprise. Availability of both TC and bank credit to high-end corporates is not affected whereas TC from them to its customers esp. SMEs have been virtually stopped which is reflected in decline in current ratio and debtors days. Their sales to SMEs are on cash-basis. These corporates with superior credit standing with banks and capital market and comfortable liquidity have the capacity to play the role of financial intermediary by extending TC to their customers. Flow of TC from these corporates is considerably weakened/chocked due to crisis of trust and confidence. Today credit sales carries higher risks of bad debts, delays, uncertainty, higher realisation costs and even possibilities of spoiling business relations. This has severely impacted the circulatory flow of credit and has muted the credit multiplier for both TC and bank credit. Further, heightened concern about credibility have led SME vendors to concentrate their credit sales to large companies. High cash-discount rates, liquidity and credits at sub-PLR give the top rated companies unequal bargaining power in purchase of inputs, advantages of bulk purchase discount and economies of scale in production and marketing. These help cash-rich companies in recording more than proportionate increase in profits compared to growth in their production and capacity built-up. In the above mentioned paper of Shri Rakesh Mohan, it is shown that average of annual growth rates in sales was 18% whereas PAT growth was 53% over the period FY 2003-07. This high growth of PAT indicate lesser competition and unequal opportunities in favour of large corporates and struggle for small businesses. Discussions with vendors of large corporates reveal that they are able to meet the offer price for their products because of their low overheads. A new vendor with borrowed capital for its new capital investment cannot even serve fully the interest and principal -installment payment. Preference for good jobs by children of SME entrepreneurs instead of managing family business indicate lower prospects and profitability compared to jobs. This is corroborated by the facts that SFCs which deal predominately with SSI are in doldrums and many UCBs which also have sizeable SSI business are not in comfortable zone. Size-wise bank credit analysis shows that share of loan-size of Rs. 10 crore and more has increased from 11% in 1990-91 to about 20 % in mid-'90s to over 40% in recent years. Uneven flow of financial resources increase gaps in income and wealth in the society. Under these circumstances, achieving inclusive growth becomes harder.

High profit-rates of corporates are not consistent with low reinvestment in productive capacities. Further reported large scale treasury operations, financial investments and repayments of debts by cash rich corporates may be due to uncertainty/ unattractiveness of return on capital expenditure. A report in a leading financial paper says that 3/4th of ECB borrowing was to take profit from arbitrage arising from disparity in interest rates.

Economic system’s inability to utilise optimally and effectively the surpluses in financial resources, foreign exchange reserves, liquidity with banks, manpower etc. into productive investment/output. There is ample liquidity in the system as was clear when Reliance energy issue of Rs. 11000 crore was oversubscribed by 72 times. In times of uncertainty and credit concerns, phenomenon of "liquidity holdback" becomes quite widespread and deep.

Despite strong economic fundamentals investments on the "sideways" of the economy i.e. real estates, stocks, consumption of life-style products/services are increasing fast compared to investment in industry. Analysts are skeptical about long-term sustainability of this trend. Rise in demand for luxury houses/real estates, automobiles, RBI Releif bonds, large investment in shares and mutual funds come from business society which indicate diversion of funds from trade and industry and lack of their confidence in investing in businesses.

Creation of new higher-end jobs in ITES, software, pharmaceuticals, finance, research, hospitality etc. sectors which are concentrated in some big cities cannot match and compensate the need for job creation in manufacturing esp. in SMEs and across the country and for all strata of the society.

High-end jobs create demand for life-style consumer products such as cars, consumer durables etc. which generally have higher import input intensity. Multiplier effect of such consumption on employment and income generation is limited. Their consumption is also greatly enhanced/facilitated by availability of bank credit. Their high visibility give an aura of economic progress and display of patches of prosperity (multi-complexes, shopping-malls, spurt in hospitality services and consumption of luxuries) which however, have a very limited trickle down effect for lower strata of the society.

It is felt that a part of higher production/sales of large companies in certain industries is due to transfer of production/sales/marketing from SMEs and weak/ sick corporates to these companies. As per CMIE’s company finance study the share of purchases of finished goods increased from 13% in 1991-92 to 20% in 2002-03. Growth rate in electricity generation was lower than the growth rate in manufacturing over the FY 2001-07 period. There is virtually no increase in absolute number of jobs in the organised private sector in the post- FY 1998 years despite higher employment in large IT companies. All these can be intuitively considered as supporting evidence of transfer/concentration of production/marketing to some large companies. 

Capital market is unable to provide stable sources of finance to manufacturing firms. Equities raised by non-Govt. non-finance companies steadily declined from Rs. 11877 crore in FY 1996 to Rs.460 crore in FY 2003. It was Rs. 1959 crore in FY 2004. There was spurt in equities raised during FY 2006 and FY 2007. However, capital raising activities in recent years are confined to a few mega-size issues.

Cost of deposits, risk-return trade-off, intermediation cost and disciplining role of market forces are not reflected in the level of BPLR/interest rates of banks. There are wide disparities in lending rates and availability of credit across firms, sectors and maturity.

Flatter-yield curve of Govt. securities across tenures indicate lower long-run growth prospects.

Maintenance of adequate liquidity, strengthening of credit creation capacity and the resiliency of FS are absolutely essential for the resurgence and effective working of a market economy. To increase liquidity, depth, diversification, flexibility of FS and to ensure availability of credit to all sections, there is need to develop/strengthen a diversified network of FS. This may include NBFCs, local area banks, capital market, private equity market, venture funds, rescue funds, discounting houses, factoring services etc. Further, resiliency of FS and an integrated policy approach to BC and NBC are necessary. To restore trust and confidence in NBC esp. in trade credit, to maintain and enforce credit discipline and to set-up a mechanism to resolve business disputes, chambers of commerce/industry associations need to work out strategy including setting up of self-regulatory organisations , credit bureaus/directories etc. at different levels. Integrity of credit culture needs to be strengthened to enhance confidence and efficiency of NBC. In this regard, strengthening creditors’ rights and its enforcement could be helpful. Self-regulation and self-discipline can work more efficiently and faster compared to state-sponsored set-ups or legal remedies as business dealings are mostly based on tacit understanding and trust. To increase liquidity, depth, flexibility of financial markets and to ensure credit availability to all sectors, there is a need to develop a diversified network of financial intermediaries.

APPEDIX 1

Turbulence in NBC

The year 1997 was a watershed year when NBC got a major jolt in the form of rapid and en-masse meltdown of NBFCs creating liquidity crisis of a systemic proportion. Circulatory flow of funds of a very large portion of NBFCs' resources comprising of public deposits of Rs.124370 crore (equivalent to 24 % of bank deposits) as at end-March 1997, funds raised through issue of debentures, loans from banks/FIs, share capital were impacted by sudden upheavals in the sector. It has a systemic fall out. This crisis was further aided and compounded by a string of events which included:

1. drainage of financial resources from NBC through Voluntary Disclosure of Income Scheme (1997) with total tax collection of Rs. 10050 crore and declaration of income amounting to over Rs. 33000 crore,
2. fresh flow of funds to NBC was severely impacted due to loss of public trust and confidence following large scale default by NBFCs and corporates in their public deposits commitments. Company deposits which were Rs. 223873 (equivalent to 45 % of bank deposits) as at end-March 1997 declined consequent upon tightening of rules and negative public perception consequent upon defaults/delays on large-scale in payment by companies including some reputed ones.
3. downturn in the capital market impacted the leverage effect of credit,
4. failure of a large number of new/expansion projects which were taken up in the post-liberalisation period characterised by optimistic outlook as either they were abandoned midway because of non-availability of required level of finance due to change in sentiments and perception of lenders or they became operationally unviable because of competition, unsustainable burden of high interest rates and economic slowdown and thereby making these investments NPA ,
5. increased level of competition for industries from liberalised imports,
6. weakening of trade credit channels following default and delays reaching a systemic proportion,
7. prudential norms and accountability syndrome in NPA cases in banks have encouraged a credit culture biased in favour of risk elimination rather than risk management.
8. East Asian crisis in 1997 and economic sanctions by the USA and Japan following nuclear explosion in May 1998 had also some adverse impact on our export and fund flow from abroad,
9. losses suffered by many investors due to securities scams, price manipulation, depressed market conditions, boom time public issues of doubtful qualities plummeted the investors’ confidence and
10. deterioration of Govt. finances, SEBs etc. resulted in lower purchases and delay in payments to their suppliers.

Financial Sickness :

Systemic fall out of weaknesses of financial system (FS) is clearly and prominently evident in wide spread financial sickness of businesses in the post FY ‘97 period. Number of cases registered with BIFR multiplied from 97 in 1996 calendar year to 233 in 1997 and 370 in 1998 and in subsequent years also there was steady growth in their numbers. The numbers were 463 and 559 in 2001and 2002 respectively. The outstanding of commercial banks relating to sick and weak units which ranged between Rs.13134 crore to Rs. 13767 crore during 1992-93 to 1996-97 spurted to Rs. 15682 crore in FY‘98 and further to Rs. 19484 crore in FY’99. It was Rs. 25776 crore in FY’01. Highest increase of about Rs.8000 crore in gross NPAs of scheduled commercial banks took place in FY’99. This increase was Rs. Rs.3515 in FY 98. It has increased by Rs 7163 crore in FY’02. Gross NPAs of public sector banks increased by Rs.10859 crore over the four year period 1998-02 as compared to increase of Rs. 4621 crore for the four year period 1994-98. This reflects deterioration in working of businesses. There was a quantum jump in gross NPAs of IDBI from Rs. 851 crore in FY’97 to Rs. 1914 crore in FY’98 and further to Rs. 2017 crore in FY’99 to Rs.16006 crore as at end March 2003. Further, despite year on year higher provisions and write-offs, ratio of net NPA to total assets of IDBI surged from 7.8% as at end March 1995 to 14.2% as at end-March 2003. Net NPAs of IFCI nearly doubled from Rs. 2213 crore as at end-March 1997 to Rs. 4231 crore as at end-March 1999 reflecting large fresh accrual of NPAs. Gross NPAs of IFCI has spurted to 55% as at end-March 2004 There was spurt in NPAs of SFCs by Rs. 1167 crore in FY’98 and further by Rs. 768 crore in FY 99. These increases in NPAs works out to 9 and 7 percentage points to SFCs’ loan portfolio respectively in these two years. NPAs for SFCs have steadily increased from 38% in FY 97 to 64% in FY 04 [Table 2]. These institutions working over 40-50 years suddenly become unviable in a short period beginning post 1997 underline the systemic impact of disruptions in NBC. IDBI’s profit after tax which was Rs. 1504 crore in FY 1998 declined steadily to Rs. 325 crore in FY 2004 despite Govt. assistance. IFCI’s profit after tax which was Rs. 594 crore in FY2000 turned into stupendous loss of Rs. 3230 crore in FY 2004 despite financial assistance from Govt. SIDBI’s loan portfolio has declined from Rs. 15194 crore as at end-March 2000 to Rs.10064 crore as at end March 2004. It is felt that these drastic swing round/ disruptions in the FS and spurt in industrial sickness can be attributed to adverse developments in NBC as there were not much of basic and sweeping changes in the economy and bank credit channels in the post- 1997 period.

A 10-year (1991-2001) financial analysis of 7487 corporate leaders (companies with turnover of Rs. one crore and above) by Prof. Krishna Kumar of IIM, Lucknow, based on CMIE data, distinctly show a steady and substantial decline in number of profit-making companies since 1997. Share of profit making companies in terms of number that fluctuated between 73% to79% during 1991-96 period saw a secular and large fall since 1997. It plummeted to 38% in 2001.

In an IMF Working Paper "Overview of the Indian Corporate Sector: 1989-2002" by Petai Topalova, concludes that the performance of the India’s corporate sector (sample of 4175 companies with networth of Rs.1,25820 crore) had weakened and its financial vulnerability has increased significantly since 1997 compared to 1989-1996 period. In percentage terms number of companies whose interest coverage ratio was less than one (indicate higher credit risk) had increased from 17.5% in 1996 to 31% in 2002. For smaller companies this ratio has increased from 24.9% to 37.4% over the same period. Similarly the number of companies with adverse current ratio (less than one), which indicate liquidity crunch, had increased steadily since 1997.

Both studies also concluded that the performance of smaller companies suffered relatively more.

Appendix 2

Role ofTrade credit (TC) or Business-to-Business Finance :

It provides credit support system to supply chain running from the stage of organization of production to sale of goods and services to the consumers. It is a kind of financial intermediation operated by businesses world over. Most inter-firm sales are made on credit terms. In TC chain a firm is both a supplier and receiver of credit. This dual role is critical in multiplying credit and thereby business growth. TC forms a substantial component of assets and liabilities of businesses. It remains the single largest source of short-term business credit in the world. It appears on every balance sheet and represents more than 1/2 of businesses' short term liabilities and 1/3 rd of all firms' total liabilities in most OECD countries. TC is 1.5 times of bank loans in USA. Intermediation of bank credit and private savings through TC by firms is quite important for an economy with limited development of its financial system. In India where accessibility to institutional credit, esp. to SMEs, being limited, it is a significant source of credit for majority of businesses. A sample study of 828 corporates in India with net sales above Rs. 10 crore over the period 1990-2001 shows that TC and bank credit were 40% and 30% of the current assets of these corporates. Total bank borrowings account for about 28% of total borrowings and TC accounted for about 34% of total borrowings of these firms. A study by RBI concludes that smaller firms depend much more heavily on TC for their funding needs. A sample of 213 SME firms located in and around Hyderabad and Gurgaon show that firms rely mostly on informal financing sources. Intermediation of financial resources that take place through firms is quite important.TC is ubiquitous. TC accounts for almost 59% of all funds of these firms. As per the Third SSI Census, only 4.5% of SSI had loan outstanding with banks/FIs. This means SSI predominately depends on NBC esp. TC. Rise of certain business communities like Marwaries in trade and industry was basically facilitated by availability of relationship-based TC.

Mostly informal nature of working of TC and the lack of structured data/information availability, developments in TC channels do not get the attention of policy makers and analysts. However, in recent years non-bank credit channels are much weakened by crisis of trust, confidence, heightened credibility concerns relating to repayments by trade debtors. Over the years TC was working more or less smoothly until it faced a systemic disturbance since late 1990s. A string of coinciding disruptive developments in financial system including sudden and en-masse meltdown of NBFCs, disruptions in ICD and repayments of company deposits combined with stricter bank credit norms impacted circulatory flow of credit and created a liquidity crisis of systemic proportion. Credit defaults in such times set in chain reaction. Trust and confidence are systemically undermined. Trade creditors being unsecured and helpless suffered the most. A sample study in one of the States in USA of small businesses which filed bankruptcy petition, shows that 66% of them were affected by non-payments by trade-debtors. Decadence of credit culture, undermining of business ethics and integrity and consequently growing tendency of willful delay/default in honouring credit commitments further strained confidence in TC network. This is reinforced as credit default/ bankruptcy no longer carries social/business stigma nor it handicaps a defaulter/bankrupt to continue his business. No more majority of people feel ashamed/morally guilty of being defaulters. Uncertainty stemming from credibility concerns about trade-debtors and weak contract enforcement impact efficiency and normal working of TC channels.

The views expressed are personal.

BLC

A discussion forum organized of Indian finance experts and management professionals   deliberated on the Draft Report of the Committee on Financial Sector Reforms (CFSR) of the Planning Commission of India and put forward suggestions for widening the benefits of financial sector reforms to a wider section of the population, and called upon the government to enlist the intellectual contribution of Indian expatriates in the Gulf and elsewhere in the policy-making process.

Indian Ambassador to Qatar Dr George Joseph inaugurated the event and emphasized that reforms work best when they take into account the financial environment in which they operate.  He also suggested that overseas Indians' role in policy evolution in the country is maturing and future overseas Indian conferences could think of focusing on specialized areas and holding them separately to contribute more specifically to government decisions.    It is for the expatriates to progressively play the role through such thought forums and thus capture a share in the process which will not be granted otherwise.

The discussion held jointly by Indian Nationals Abroad (INA) and Middle-East Indian Management Association (MIMA) at Al Dana Club, Doha, State of Qatar was attended by Indian management professionals in Qatar and by senior executives of Indian banking institutions and Indian industrial organizations operating in Qatar.    Mr Kalayanasundarm, General Manager of IT with Bank of India, who spoke as a guest of honour at the meeting, dwelt on the changes taking place in Indian banking sector such use of modern Information technology to reach a wider, more rural population to make banking sector more inclusive, even with hand-held computerized devices that delivers banking service to the door in villages.   But agricultural land and per capita land holdings in the country are going down side by side with the rise of the share of service sector in country's Gross Domestic Product (GDP), which he said needs to be addressed for necessary fine-tuning in economic models.  Such models can include agricultural land ownership being turned into corporate or co-operative group holdings and more modern farming in order to protect the farming sector.

In his keynote address,   Mr R Seetharaman,  CEO of Doha Bank dealt extensively with items of the CFSR including the banking sector.    Amidst the economic combination of factors like globalization, deregulation,  technology and consumerism,   he said, Indian economy needs further reforms to realize benefits of globalization  and deregulation,  and not fall into the ills such as economic indiscipline and debt-trap that are noticeable in economic crisis like sub-prime mortgage crisis of the US.   Amidst increasing consumerism individuals should not be tempted to overstretch themselves and over borrow. When growth rates of India and China are far higher than that of the US and most of Europe, and when free flow of funds can do wonders, there is a strong case for increasing the level of utilization of sovereign funds available in the Gulf and other countries, from the currently insignificant levels and the banking sector to permit more liberal participation of foreign banks.   Mr Seetharaman also recommended considering the Sharia-based banking systems and Shariah-compliant products that would greatly protect the interests of entrepreneur and the banks.    Equity-based finance in an ethical banking model has proved its advantages over interest-based lending in the region's experience and can be considered for emulation in India also,  where however RBI has not approved it thus far.     While the Raghuram Rajan Committee report includes several encouraging items,   he wished the final package to also address social welfare aspects, environmental issues resulting from development, and of integrating the Indian economy with its immense knowledge capital into the world system of knowledge-based economy.

Mr. M.A.Salim, Technical Operations Coordinator, Refining Operations, Qatar Petroleum Refinery and President of Qatar Indian Management Association proposed introduction of "Energy credit" which is similar to "Carbon Credit "of environmentalists. "Energy Credit"can be a tradable commodity in the market.

Mr Nizar Kochery, President of Middle East Indian Management Association, opened the session and highlighted the significance of the event as a first time participation by expatriate Indians in contributing thoughts to policy making.  The programme was sponsored by Indian public sector Banks such as State Bank of India (Trust Exchange),   Bank of India (Al Mana Exchange),  Syndicate Bank (National Exchange) and followed by a Question and Answer session and panelists answered queries.   The programme was compered by Rajeev Thomas from Qatar Foundation and P.V. Saeed Muhammad made a summary of chief recommendations that emerged from the discussions.

The reports (in PDF formats):

1. Role for expats in India financial reforms urgeed
2. Recommendations made by meeting of Indian fianance and management professionals organised in Doha, Qatar on 26th May 2008
3. ndian financial reforms results to penetrate low, wider : INA and MIMA debate

NK

Dear Sir,

At the outset, the Institute of Chartered Accountants of India (ICAI) commends the High Level Committee on Financial Sector Reforms set up primarily to consider and recommend reforms in the area of financial sector for putting forward a thoroughly comprehensive report based on intensive analysis of literature and data. Chapter 6 of the Draft Report dealing with a growth friendly Regulatory Framework and financial architecture amongst other recommendations also makes a reference to an improved system for audit of listed and unlisted companies. While looking at the complete structure of the Draft Report, one gets an impression that this particular recommendation stands in isolation because the same does not appear to be based on an in-depth study of the evolution of financial reporting regulatory framework in the country. Through this communication, we wish to put on record certain facts and our response to specific observations made in sub-para(9) of Chapter 6 of the Draft Report for consideration of the Committee.

3. Consequently, Chapter 3 "Auditing the Auditors" dealt at length the setting-up of Public Company Accounting Oversight Board (PCAOB) of the SOX Act and specifically considered the most debated question, "Should India have its Public Accounting Oversight Board?" In this respect, the recommendation of the Naresh Chandra Committee is reproduced below:

"The Committee deliberated long and hard on the issue of whether it was necessary to establish a new, independent Public Oversight Board (POB) for supervising the work of auditors - such as the one proposed in the SOX Act. On balance, the Committee felt that there is no need at this point of time to set up yet another new regulatory oversight body. However, the Committee felt that there is a need to establish an efficient and professional body which can be entrusted to provide transparent and expeditious auditing quality oversight. This will be in the interest of investors, the general public and the professionals themselves. With these considerations in mind, the Committee has recommended the setting up of independent Quality Review Boards." (Paragraph 18)

Following the recommendations of the aforesaid Committee, the Government of India has since amended the Chartered Accountants Act, 1949 and set up an independent Quality Review Board(QRB).

4. Before we respond to specific observations, it is important for us to state that the Institute of Chartered Accountants of India (ICAI) has been set-up under the Chartered Accountants Act, 1949 to regulate the profession of Chartered Accountants in India. For this purpose, the Council of the ICAI comprising of eight nominees of Government of India has established number of Boards and Committees to address regulatory and developmental issues such as technical competence, ethical and independence issues, accounting standards, auditing standards, continuing professional development, etc. Some of the important Committee(s)/Board(s) are:

5. That besides, the ICAI is addressing contemporary developments in area of Public Finance, Accounting for NGOs, Government Accounting Reforms to mark its contribution beyond the Corporate world. It through its internationally bench marked qualification and training system has developed a cadre of over 145000 members who have been serving the nation either as practicing accountants or being part of the corporate world and has over 350,000 students pursuing Chartered Accountancy Course at its various stages. Today, the ICAI is the second largest accounting body worldwide and a prominent one playing a pivotal role in all international fora on accounting including the standard-setting bodies.

First of all we respond to the need for setting up of an Oversight body on the pattern of PCAOB of the United States recommended in the Draft Report as under:

6. Having regard to developments in early 2000 and deliberations of the Naresh Chandra Committee, the ICAI suo motu established the Peer Review Board in April 2002 (Naresh Chandra Committee submitted its Report in August 2002) comprising of members of the Council, representative from the Ministry of Corporate Affairs, the IRDA, the SEBI and the industry. A scrutiny of the Institute’s proceedings would conclusively establish that the process of establishing such an oversight mechanism was under active consideration since 1997. The process of peer review formulated by the ICAI is an amalgam of best of the international practices and as such it is only those individuals who have got requisite experience and skills , are appointed as reviewers. The peer review process covers all Practice Units in the country and follows an appropriate combination of cycle approach and risk-based approach keeping in public interest perspective.

7. Recently, SEBI’s Committee on Disclosures and Accounting Standards (SCODA) recommended that in view of the public funds involved, audit of listed companies should be carried out by those auditors only who have undergone peer review. The said recommendation of SCODA has been accepted by the Council of the Institute. Such recommendation substantiates the value of peer review process.

8. Though primarily peer review process is established as a quality enhancement mechanism, it has created an extensive awareness amongst all members across the country about the need for observing the technical and professional standards including ethical standards. Pursuant to recommendation of the Naresh Chandra Committee, the Chartered Accountants Act,1949 was amended in 2006 to provide for the constitution of independent Quality Review Board and the significant reforms in the legal framework for disciplinary mechanism. The Central Government by way of notification in June 2007 has constituted the Quality Review Board (QRB). In a short span of 11 months since QRB became operational, five meetings have been held till date to lay down process and procedure for quality review.

9. The Act as amended by the Amendment Act of 2006 provides for setting up of independent Directorate of Discipline and for the constitution of the 3 member Board of Discipline including a presiding officer who has knowledge of disciplinary matters and the profession, and a person nominated by the Central Government out of persons of experience having eminence in the field of law, economics, business, finance or accountancy. The Board looks into complaints which fall under the First Schedule to the Act. There is also a five member Disciplinary Committee including two members nominated by the Central Government from amongst persons of eminence having experience in the field of law, economics, business, finance or accounting. The Disciplinary Committee looks into complaints against members falling under both the First Schedule as well as the Second Schedule to the Chartered Accountants Act, 1949.

10. In view of evaluation done by the Naresh Chandra Committee in the Indian context and subsequent developments, is it not plausible to say that perhaps PCAOB is a mere concept in the context of Indian regulatory framework. As is also evident from the evaluation done by the Naresh Chandra Committee, PCAOB(US) set up in the US context could at best be a mere concept and not relevant under regulatory framework and circumstances prevailing in India and, thus, not needed.

Now we shall move on to other recommendations contained in the Draft Report to initiate the process of review of annual reports on a sample basis. Our submission is as under:

11. The Council of the ICAI suo motu constituted Financial Reporting Review Board (FRRB) in July, 2002 precisely to undertake this function. The primary function of the FRRB is to review the compliance, inter alia, with the reporting requirements of various applicable statutes, Accounting Standards and Auditing and Assurance Standards issued by the ICAI.

12. The FRRB reviews the general purpose financial statements of the enterprise and the auditor’s report thereon either suo motu or on a reference made to it by any regulatory body like, Reserve Bank of India, Securities and Exchange Board of India, Insurance Regulatory and Development Authority, Ministry of Corporate Affairs, etc. The FRRB also reviews general purpose financial statements of the enterprises and the auditor’s report thereon relating to which serious accounting irregularities in the general purpose financial statements have been highlighted by the media reports.

13. As a process of effective monitoring mechanism, in case the Financial Reporting Review Board finds any non-compliance with the factors stated above in para 11, it refers the case to the Secretary/Director (Discipline) of the Institute of Chartered Accountants of India for initiating action against the auditor under the Chartered Accountants Act, 1949. The ICAI is not authorised under the law to call for clarifications from a Company (as also observed in the Report), the FRRB informs irregularity to the regulatory body relevant to the enterprise. The statistics reveals that, out of 187 cases taken up for review up to 2007-08 , 68 cases have been referred to the Secretary to the Council/Director (Discipline) of the Institute and almost similar number has been till referred to regulatory authority relevant to the enterprise.

14. It is beyond doubt that only those persons who have necessary technical competence, skill and expertise in the area of financial reporting are entrusted to undertake this task. We are confident that the ICAI as the focal point for undertaking this task had added credibility to the entire review mechanism by following a highly objective and robust process. At present, the ICAI has jurisdiction over its members only and in case, the ICAI is entrusted with relevant power to seek clarification from companies; it shall further enhance the objective of review of annual reports.

Regarding recommendation to create the Accounting Oversight Board for performing several functions including moving towards international audit standards, verifying standards of transparency and governance of audits at public firms, and sustaining the capabilities of auditors at high levels, the ICAI wishes to put on record the following:

15. Before we share our experiences in the area of formulating and implementing Auditing and Assurance Standards(AASs) vis-a-vis International Auditing Standards(ISAs), we wish to bring to the Committee’s notice the Report on Standards and Codes (ROSC) which was a joint initiative of the World Bank and the International Monetary Fund aimed at assessing the level of compliance in the member countries of the twelve core principles enunciated by Financial Stability Forum, comprising assessment of actual practices as well as the effectiveness of the monitoring and enforcement mechanisms.

16. The ROSC 2004 was finalised by the representatives of the World Bank through a participatory process involving various stakeholders such as the Ministry of Corporate Affairs, the Reserve Bank of India, the Institute of Chartered Accountants of India, the Insurance Regulatory and Development Authority, the Securities and Exchange Board of India, the Comptroller and Auditor General of India etc. Some of the significant findings of the ROSC 2004 were as follows:

17. The ICAI being a founder member of the IFAC, has followed since inception a conscious policy of harmonization with the International Auditing Standards, which, accordingly, forms the basis for the national standards (i.e., Auditing and Assurance Standards) subject to any modifications arising out of the requirements of laws and regulations or customs and usage of trade. The ICAI’s Auditing and Assurance Standards Board has not only already initiated an ambitious project of revising all its existing Auditing and Assurance Standards in the light of the various ISAs being issued by International Auditing and Assurance Standards Board (IAASB) under its recent on going Clarity Project to achieve convergence with the same and is further looking forward to meet the time line set by IAASB for winding up the Clarity Project.

18. As the first and the most fundamental step towards convergence, the AASB has recently issued the Revised Preface in line with the Preface issued by the IAASB. The Revised Preface paves way for the introduction of Standards written in a format which is in harmony with that adopted by the IAASB for its ISA under the Clarity Project. Further in terms of a recent policy of the IAASB, no National Standard Setter (NSS), for example, like the ICAI can claim to have achieved convergence with the International Standards unless, among other things, it has a Standard equivalent to the International Standard on Quality Control (ISQC). The ICAI has also issued a mother standard on quality control corresponding to the ISQC.

19. In India, the ICAI constituted Accounting Standards Board in 1977. Since then it is working to provide a sound and reliable accounting and financial reporting system in the country by issuing new Accounting Standards as well as revising the existing Accounting Standards from time to time and in line with the International Accounting Standards (IASs). Moving forward in this direction, the ICAI issued a Concept Paper on Convergence with IFRSs in India, and decided to adopt the International Financial Reporting Standards (IFRSs) from the accounting periods commencing on or after 1 st April, 2011 in respect of the listed entities and other public interest entities such as banks, insurance companies and other large-sized entities.

20. Accounting Standards issued by the Institute got legal recognition in October 1998 with the insertion of section 211 (3A), (3B), and (3C) in the Companies Act, 1956. Section 211 (3C) of the Act provides that the Accounting Standards issued by the ICAI may be prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards (NACAS) and proviso to the section provides that until the notification of the Accounting Standards by the Government, Accounting Standards issued by the Institute are required to be followed by the companies. Recently, the Ministry of Company Affairs (now ‘Ministry of Corporate Affairs’), Government of India, has prescribed Accounting Standards 1 to 7 and 29 vide its notification dated December 7, 2006, in the Gazette of India, to be effective in respect of accounting periods commencing on or after the publication of these Accounting Standards (i.e., December 7, 2006). The NACAS is constituted by Government of India with representative from various stakeholders, and reviews accounting standards formulated by the ICAI before recommending these for notification by the Government of India.

21. With the primary aim of capacity building and encouraging the learning process mechanism throughout the life of a professional, the Council of the Institute, in 1956, constituted the Continuing Professional Education Committee. The Institute has always recognised the significance of Continuing Professional Education (CPE) for its members and pursued it as one of the avowed objectives so as to ensure that its members attain and maintain the quality of knowledge and service expected of them. It is with this end in view that the Institute has taken upon itself the task of providing continuing education to its members on a regular and systematic basis and made it mandatory for members in practice since 2004. As a part of the continuing professional education, the Committee through its various programme organizing units, organizes a number of seminars, workshops, conferences, etc., on various areas of professional interest, including auditing. The CPE Committee organizes programmes, for example, on broad areas such as Taxation, Auditing and Assurance Standards, Accounting Standards, Information Technology, Corporate Governance, etc. From 2008, the CPE has become mandatory for the members in industry as well. The ICAI through its various organs generates about 1.5 to 2 million CPE hours for its members every year.

Finally, regarding recommendation for consideration of adoption of a standards-based way of communicating business and financial information to facilitate the regulatory review process, we wish state the developments regarding Extensible Business Reporting language (XBRL), as under:

22. Taking into account the immense importance and usefulness of XBRL, the ICAI has constituted a group on XBRL for development of XBRL in India and its promotion amongst various stakeholders. We have already taken up development of taxonomy of XBRL-based reporting bearing in mind the peculiarities of Indian Accounting Standards and the legal and regulatory framework. The Indian Accounting Standards being harmonized to IFRSs and with the full convergence with IFRSs slated for 2011, the ICAI would be customizing - IFRSs based taxonomy to suit the Indian Scenario. The general purpose commercial and industrial taxonomy is expected to be ready by the end of July, 2008. Thereafter, sector-specific taxonomy for banking and insurance would be taken up. Besides developing the taxonomy, the ICAI is also aiming to establish the ICAI as the Indian Jurisdiction of XBRL International, which is a non-profit consortium of a large number of major companies, organizations and government agencies. The Ministry of Corporate Affairs and various regulators namely SEBI, RBI and IRDA are supporting the Institute in establishing the ICAI as the Indian Jurisdiction of XBRL.

23. From the above, it is evident that the review of the regulatory mechanism of the accounting profession undertaken in the recent past, including as a consequence of corporate debacles in the various parts of the world and the introduction of SOX requirements in the US , endorsed the existing framework with some changes in the structures like setting up of the independent Quality Review Board. The Government of India as well as the ICAI have taken measures from time to time through amendments in the Chartered Accountants Act, 1949 and taking other proactive initiatives in the dynamic context to make the framework more robust in the public interest. In view of the regulation and structure of the accounting profession in the US being far different than in India, the concept of PCAOB set up in the US context is not elevant for India. Further, the accounting standards and auditing standards in India are also benchmarked with international standards and are being continuously aligned with the changes taking place in the international standards.

We shall be happy to provide further information and clarifications, if required.

We are also looking to an opportunity to present our views and information to the Committee in person.
VJ

Dear Sir,

The Report deals with the financial sector in great details. However, unfortunately, the commodity sector and the issues and challenges faced by it have not been analyzed therein.

Prima facie, two of the four terms of the Reference of the Report indicate reference to the spot commodity (real) market and the related financial (commodity derivative) market as follows:

1. To identify the emerging challenges in meeting the financing needs of the Indian economy in the coming decade and to identify real sector reforms that would allow those needs to be more easily met by the financial sector.
2. To examine the performance of various segments of the financial sector and identify changes that will allow it to meet the needs of the real sector

However, even while covering these issues on the broader canvas, the commodity sector has, unfortunately, not been given its due place.

The conclusions for regulatory convergence by way of merger of SEBI and FMC are based on a preconceived romantic idea of a single regulator rather than based on realistically assessed country-specific merit based conclusions. Interestingly, the Committee has neither seem to have any commodity sector experts as members nor do have consulted, discussed or taken feed back from such market players / experts. Nor are the issues confronting the fragmented physical market analyzed before coming to this conclusion on regulatory convergence. Internationally, there are various models of Regulation [Single (U.K, China and Australia), dual ( USA) and multi ( Japan, Dubai). These Regulatory models have evolved over a period of time and each model has its relative merits and demerits, and till date, we do not have a clear evidence of superiority of a unified regulator over separate regulators. The recent move in some jurisdictions towards, unified regulations doesn't necessarily prove the superiority of unified regulation over decentralized regulation. The decision of convergence of the regulatory system should not be based on perceived economic benefits in terms of economies of scale, increase in liquidity, etc., but the real issues that are of concern to the underlying real economy and to policy makers and the value that would be brought to the Eco system and whether a unified regulator / regulation would help the markets play the intended role of price discovery and risk management to the actual stake holders in the physical market or not.

The comments of the Forward Markets Commission on the Report are attached.

With regards,
AM

Dear Sir,

Committee has done a commendable job in covering the reforms needed in financial sector in its entirety. However, I would like to add up the following from my side on this topic:

A recent joint forum publication 'Credit Risk Transfer, April 2008' available on BIS comes out with startling revelation in relation to product innovation and lag in supervisory understanding of the same. It talks specifically about structured finance and how rating agencies rating of the instrument failed to capture default risk. Unbridled product innovation without understanding the full implication of the new product may still pose a major systemic risk.

Emergence of a liquid bond market (including corportae bond market) has its genesis in valuation of securities. In declining interest rate market banks / financial institutions were happy trading heavily, and sometime even irrationally, as they were able to convert their wealth into income, in the process earning praise for making up for the banks impaired capital base . Same has recoiled back on reversal of interest rate as any trading was sure to be booked as losses, thus bringing down the volume of trade substantially as can be seen in the post 2004 scenario.  Mark to market has not helped resolve the situation as their seems to be a bias among traders/banks against the realized losses. Issue could be the directive about valuing  specific percentage of portfolio as HTM/AFS and HFT  making it attarctibe for banks to go for Loans as against Bonds in a declining interest rate scenario. This report does indeed provides this insight and has been right in identifying the other impediments to evolution of corporate bond market.

Also report seems to overlook the fact that 180 days duration for recognizing NPA in agri sector might have its genesis in cycle impact of crop failure ( considering a three crop cycle).

Also in case of differential incidence of taxation, ideal way out could be levy of tax on differential incidence of tax between the home country and the host country. same should be incorporated in double taxation avoidance treaties.

Junking the government support to certain financial institutions roundly may be counterproductive. Government support may still be a better option in retaining public confidence in financial system in a country where illiteracy rate itself is so high, not to talk about financial literacy.

A reason for number of financial imprudent decisions have their genesis in the compensation structure which are most of the time not designed to assess the actual performance of the management. They are designed to reward people in charge who are at the helm of affairs at the right point of time. Hardly any performance measure prevalent today takes into account the external factor neutral performance of management.  A management may be doing a commendable job in cutting losses during lean period but does not get the same recognition which even a market under performer might have got during the boom time. Indian financial sector should look into this aspect carefully, as an ill designed compensation structure will be a sure shot recipe for disaster.Ill conceived compensation structure may disincentivise making of long term prudent decision in organizations interest.

Though I would agree that directed lending should be done away with, however, the alternative suggested may not curb the institutional bias against the perceived difficult segments. I'll rather agree with the stipulation that priority sector lending must be made more narrower and focused in order to be well targeted. Instead of regulating the interest rate, government may well look at levying cess on income from lending to other sectors and put the same in hands of RBI to provide  Interest Rate  Subsidy directly in hands of well targeted priority sector borrowers. There is a strong case for making agriculture remunerative for future food security. A  reduced input capital cost would be still desired to achieve this objective. Having an economy disproportionately dependent on tertiary sector can not be an ideal situation in any case. 

DNM