Dr. Bimal Jalan - Governor, Reserve Bank of India     


Investorsí Choice: Public Vs. Private *

The second half of the nineties has been characterized by considerable uncertainty and stress for the global financial system. Some have characterized this period as a period of the worst prolonged series of international economic crises since the 1930s. That may or may not be true, but the fact is that we are going to see a whole series of problems before things settle down. It began with Thailand, and spread all over East Asia. It was supposed to be regional. Then it spread to Russia, and now to Brazil. So it is taking an International dimension. More than that, the most striking fact about these crises is that though their origin could be traced to other areas, they have all revealed themselves in the financial markets first. The origins of the crises must have been in macro-economic or micro-economic policies or bad management or banking sector, but the first manifestation has been, in one way or another, in the financial markets. That is a matter of some importance.

Unlike the previous crises, this is the first time that countries which were otherwise believed to be sound have succumbed under the pressure of one kind or another in the financial markets. This has generated a tremendous amount of focus on the handling of banking and financial sector that is, on prudential norms, supervision norms and so on.

So my first point for your consideration is that financial markets and institutions can no longer be perceived as a domestic issue. Our ability, for example, to transact goods and services or capital with the rest of the world would hinge very much on what the rest of the world thinks, rightly or wrongly, about the strength of our banking and financial sector.

This is an extremely important conceptual change, in the sense that it is not an issue for the Reserve Bank or the Government of India or the experts sitting here but everybody else who is watching our financial sector. When outsiders lend to you, provide export finance, and trade with you, they would be looking at the banking and financial sector. This is evident.

Earlier, financial crises were supposed to be the result of something going wrong in the real economy or in the debt market. Today there is a perception and may be this perception will change, that the financial systems, the banking systems and the flows of capital are in some way behind a lot of turmoil that we have seen in recent months. Therefore, there is a tremendous amount of attention on how we regulate and develop our financial markets. I would like to repeat here that it is no more a domestic issue, but is an international issue.

Balancing regulation and freedom

The second point, which is an old debate, is about the exact balance between freedom and regulation. I think most people would agree that markets, whether product or financial markets or any other markets, need some sort of regulation, which is macro-economic, to make people aware of what the rules of the game are. In India, we had too much regulation in the past, too detailed a regulatory system and very little freedom. In East Asia, the current view is that there is too much freedom and too little regulation.

So, in the world today, there is considerable amount of debate on the appropriate balance between regulation and freedom. What I would like to emphasize in regard to this issue of balance is that while it does cover the product markets, it becomes much more important in respect to the financial markets. Today, as I see, even in the freest of the economies, there is a tremendous amount of focus on supervision and regulation of financial systems. A strong supervisory and regulatory system in the financial markets is a must.

Now, why do we need it? I think the major reason really is that, unlike the product markets, the financial market is one sector where what the economists call negative externalities can be quite important. That is, if something goes wrong, it hurts not only those who are participating directly in the system but everybody else around them, including the system, the economy and everything else.

Regulation and public ownership

With regard to financial regulation, we have to pay a great deal of attention to prudential and capitalization norms. All these things are now somewhat painful in India, particularly because the Indian systemís non-vulnerability arises simply from its public ownership, and this is not good enough.

We have to move towards a supervisory and regulatory system, which is seen to be strong and believed to be strong, not simply because most of our financial sector is publicly owned. That will not be financially viable or strong. This is another issue which needs attention.

We have to move towards not only disclosure and transparency norms but also towards regulatory and supervisory norms, which should meet the best international tests. It does not mean that we should direct traffic in every corner, but that we need to concentrate on a few crucial prudential regulations, like capitalization or NPA norms, provisioning norms, etc., and have systems which are internally strong so that if any problems emerge, there is transparency and full disclosure.

Regulation of intermediaries

A related issue is that in the financial sector there are two kinds of markets; one, financial markets where individuals trade with individuals or through brokers. This is direct trade. The capital market is an example of that. Then you have financial intermediaries, that is, banks, financial institutions, NBFCs, who act as intermediaries between the providers of capital and the recipients of capital. The regulatory and supervisory challenges regarding financial intermediaries are very different from those regarding financial markets trading directly.

It is in the case of financial intermediaries that the whole supervisory-regulatory system assumes much importance in India. It has to go beyond transparency, level playing field, etc., because we have to make sure that the actions of the intermediaries do not lead to systemic problems or to excessive external negativities. Therefore, while talking about the financial system, I do not think we can lump this whole thing together.

In different parts of the world, there are systems where financial intermediaries have dominated the markets, like perhaps in Japan, and there are systems where financial markets are dominant like in the US and also perhaps in the UK. This has relevance to some of the technical discussions that have been scheduled in the seminar. Are we talking about markets or about intermediaries? The approach cannot be exactly the same towards these two types of players or constituents of the financial market.

Individual saverís confidence is the key

A different point that I would like to raise is that financial markets cannot really develop, irrespective of how much freedom there is or how much regulation there is, unless they are made safe for individuals. In our system, it is the household savings which are the predominant part of the total savings. Hence, unless the private saver of money is able to operate with a certain amount of confidence in the equity and bond markets directly or through intermediaries, we cannot have a well-developed financial market. If we want to shift from a system which is today dominated by intermediaries to a system which is dominated by markets as it were, then it is the individual buyers and sellers who have to be given maximum attention. Then the problem goes beyond merely one of regulation. You can have very well regulated and very transparent markets, and yet it may be a market where the individuals do not want to operate.

I was most impressed by some of the recent data about the preferences of savers in India. Based on a survey, it has been reported that only 15 per cent of the people felt that non-government bonds are safe. In contrast, nearly 80% of the people felt that the bonds floated by the IDBI are safe, although the IDBIís profitability picture is different and the marketís reaction to IDBI shares is different when compared to some of the private companies. Now, why is there this kind of perception? This is an important issue, If we want to develop financial markets, it is obvious that we have to set rules which will take care of the problem of maintaining investorsí confidence.

Of course, a part of the reason behind the problem, is the high default rate on non-government company bonds. Default of one kind or another on such bonds was reported by about 25% of the bondholders and further, 50% of individual investors had complaints against companies and 35% of them had complaints against brokers. These are striking statistics.

One reason why government bonds are preferred is that they give you a return irrespective of actual commercial yields. That is one fact. The second fact is that, in our system, there is no penalty on private companies dishonouring the bonds or not responding to customer complaints. I think that strict rules have to be developed to deal with this problem.

If this is the kind of situation that exists with regard to private company bonds, and if people feel that the only bonds they should buy are IDBI bonds or the government bonds, then how do we develop a bond market? This is an extremely important issue which, I think, should require some consideration in this high-level forum.

Creating bond liquidity

Finally, to conclude, there are three areas in our financial markets which need a lot of work and development. One is, of course, the debt market which you would be discussing in one of the sessions. The Reserve Bank is trying to do something in this area but the focus is extremely narrow. We have auctions of 14-day 30-day, 90-day, 365-day treasury bills, but the players are very few. Then there is the institution of primary and satellite dealers, but the debt markets are really not liquid so far, particularly from the point of view of the private investor. This is an area that requires a lot of attention, especially if we want to move to a more integrated financial system, where investors will be able to get into debt or equity, as they wish. Today the markets are not liquid enough for this to happen. If there are any suggestions on that score, the Reserve Bank and other institutions would be most interested in knowing about them.

The development of the debt market goes beyond the government securities market. Though this market can provide us with benchmark rates, ultimately what we need is a market in bonds that would enable us to deal in institutional bonds. I do not think there is a market for institutional bonds, the kind of bonds that are so much preferred by individuals. They are highly illiquid in a way.

Attend to venture capital development

Second is venture capital. This is another area where a lot of talk has gone on but not much has been achieved. The issues involved go beyond regulation, freedom, liberalization, etc. Venture capital is an area where much needs to be done because that is really the wave of the future. I mean that most of our companies which are doing well in the stock markets are new companies. They are not the old-established companies with a lot of capital and management history. So this is another area that needs a great deal of attention. Now, venture capital does not need to be adventurous. There are venture capital institutions and methodologies which make the financing of such companies commercially viable. We have to develop this area. The institutions are trying to play a role but they need to play a much more vital role.

The challenge of financing service industries.

The traditional concept of services in our country has to change and it is, in fact, changing. I mean that service is not an adjunct to manufacturing. In development economics, we were told that the service industry is a by-product of manufacturing somewhere in-between, not really an independent thing, and that what we really need is manufacturing and primary products. This is no longer true anywhere, including India. Designing, marketing, computerization, information, are all connected with the service industry.

The reason why I raised this issue, and the stock markets have recognized it too, is that Indiaís relative advantage is in that field. For example, there are software companies which have done very well, but it is the financial intermediaries which have to pay much more attention. New guidelines have been issued but since it is not tangible, we do not seem to have a progressive approach in providing finance for the service industry. This is an area where our system has not risen to the required level. We need to pay urgent attention to accelerating the flow of finance to the new services sector.

* Excerpts from the address at the High-level Seminar to discuss the need for re-engineering Indiaís Financial Markets and Institutions by Society for Capital Market Research and Development, Mumbai, January 1999.

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