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CFSA recommendations for more stable, inclusive markets
June 11, 2009

The Government and Reserve Bank of India (RBI) released the Committee on Financial Sector Assessment (CFSA) Report in March 2009. The report was undertaken to examine the health of Indian Financial System by stability assessment, stress testing and compliance with all financial standards and codes. We review pointers from this report that are beneficial to investors and essential for future development of financial markets.


Author : Dhanashri Rane



Untitled Document

India’s financial sector is at the cusp of an important phase of growth, and we’re already seeing a lot of dialogue around us on how to accelerate this growth. As retail investors we’re bound to come across a lot of new (and inviting) investment options open up for us, and as participants of the market, it pays to be well informed about its stability, the set financial standards, and the possible ways in which we can participate in a safer and more beneficial manner.

As we speak about the financial system in India, let us first look at the range and depth of the markets. We can broadly classify the markets into equity, money market, foreign exchange, government securities, corporate bond market and credit market.

Graph 1 shows the phenomenal growth in average daily turnover in each of the market segment over the last eight years.

CFSA report speaks of following factors to have contributed to the growth of financial markets:

  • Enabling price discovery mechanisms

  • Lowering of transaction costs

  • Improvement in trading and settlement systems

  • Deregulation of interest rates

  • Better market infrastructure

  • Enhancing liquidity

The sharp rise in derivative trades can be attributed to introduction of index futures and options plus stock futures and options.

 

Graph 1: Average daily turnover (Rs. Crore)

(Source: CFSA report)

Highlighted here are some of the findings and recommendations from the Report:

  • Expansion of banking system is crucial in order to maintain a GDP growth rate of 8-9%.  Public sector banks (PSBs) require adequate capital for expansion of business. A reduction in government shareholding will facilitate the growth without additional fiscal burden. More importantly, the CFSA report states that the governance in the PSBs needs to undergo improvement at board level.

  • There has been a significant rise in lending towards the retail sector. The increase is evident from the retail credit portfolio of banks. One of the worrying factors has been lack of data on household loans and absence of an indicator (Loan To Value ratio) for the property market. The report has initiated introduction of Housing Price Index to assess the real estate prices as well as cost of housing credit in the country. National Housing Board has worked on data for 5 cities which is expected to be rolled out for a population of over 10 lakh in 63 cities.

  • The committee has recommended the setting up of a Central Integrated Platform that will enable investors to participate in public issues electronically, help strengthen surveillance practices across exchanges and markets and simplify debt issuance process.

  • Stock markets in India faced a steep fall across major indices and an uncertainty on account of global financial turmoil. Markets have shown a high correlation with developed countries and Asian peers, with the exception of China and Korea. Open interest position or outstanding contracts in stock futures have witnessed a sharp rise which can lead to volatility in the spot market. Increased volatility can negatively impact market sentiments and the ability to raise capital from abroad for the corporate sector. The report calls for judicious capital account management with well sequenced and prudent approach towards fuller capital account.

  • There is a scope for improvement in the business environment by means of favourable tax laws and sources of long-term funding. A mature bond market will ensure easy access to credit for corporations. CFSA report states that the development of nascent corporate bond market can be initiated with reforms in pension and insurance sector.

  • The buoyant stock markets in recent years led to 267 initial public offerings (IPOs) amounting to Rs. 86,471 crores between financial year 2003 (ending 2004) to 2007 (ending 2008). Primary market issuances require qualified institutional buyers to pay minimum 10% of the application money as upfront margin money. CFSA shares a cautious viewpoint that institutional bidders should pay the total amount as upfront instead of a small percentage amount. The reason is that the current requirement of at least 10% bid amount by the QIBs creates hype especially, during a bull run, IPOs attract hype about over-subscription of the issue. The buildup on over-subscription may drive many retail investors to the market. However, the investors may not have adequate information about the promoters of the company, purpose of raising capital, company fundamentals and pricing of the issue.

  • Voting patterns of significant shareholders must be made public for better transparency and stakeholders’ benefit.

  • The controls for rural banking sector are divided between Reserve Bank for banking regulation and NABARD for supervision. CFSA opines that the management and supervision of rural co-operatives and rural financial institutions must be handled by a separate regulatory authority. This is to avoid conflicts of interest, to enhance cost and supervisory efficiency and for better corporate governance. NABARD should function solely as a development financial institution.

  • CFSA concurs with the IRDA guideline of positioning ULIPs as a long-term investment option, rather than pairing it with Equity Linked Saving Schemes of mutual funds.

  • Deposit insurance protects bank depositors against bankruptcy. The stress tests conducted by the committee concluded that Deposit Insurance and Credit Guarantee Corporation (DICGC) which is fully owned by the Reserve Bank can meet claims in worst case scenario. Equally, the efficacy and adequacy of deposit insurance funds needs to be monitored at all times.

Conclusion

With this article we aimed to provide information about the recent assessment of our financial sector. Reforms and policies can accelerate the growth of financial industry. Ensuring best practices and financial soundness is critical for stability of any financial system. Hence, initiatives like stress testing analysis are welcome. However, it was found that non-availability of satisfactory and heterogeneous data is a major drawback to carry out the stress testing exercises successfully. Lack of a comprehensive macro-economic model for a high growth and evolving market like us, is a concern.

The financial assessment should involve initiatives for retail investor participation. Transparency and institutionalised information sharing will create awareness amongst the investor community. There is a need to create a framework for timely disclosures and uncover latent vulnerabilities. We believe that there is still a long way to go to build investor confidence and ensure financial inclusion.


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