Impact of Financial Sector Reforms On Ec PDF

IRJMST Volume 5 Issue 3 [Year 2014] Online ISSN 2250 - 1959
IMPACT OF FINANCIAL SECTOR REFORMS ON ECONOMIC GROWTH IN

INDIA
AUTHORED BY:SHWETA GARG

Research aspirant, Department of Commerce, Delhi School of Economics, DU
shwetagarg18@gmail.com
Co-AUTHORED BY: SHIVANI GARG

Assistant professor, Ramjas College, Delhi University
shivanigarg01@gmail.com
INTRODUCTION
THE FINANCIAL SYSTEM
The term ‘Finance’ in our simple understanding is perceived as equivalent to

money. It is, however, not exactly money, rather a source of providing funds for any
particular activity. The word ‘system’ implies a set of closely inter-connected yet
separate institutions, agents, practices, markets, transactions and so on working together
to achieve some purpose.
Financial System thus imply a set of complex and closely connected institutions,
agents, practices, markets, transactions, claims and liabilities that work together to
provide funds for different economic activities. Conceptually, financial system includes
complex institutional arrangements for mobilizing financial surpluses from surplus units
and transferring these to deficit spenders. These institutional arrangements includes all
conditions and mechanisms governing the production, distribution, exchange and holding
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of financial assets of various types and the organization as well as manner of operation of
financial markets and institutions.
A financial system helps to promote savings and appropriately allocate the

available funds. It is concerned about money, credit, and finance: closely related, yet
different from each other. Money refers to the current medium of exchange or means of
payment. It also serves as a store of wealth and unit of account. It consists of coins, notes
and deposits with banks withdraw able on demand. It is a liability of the banking system.
Credit or loan is a sum of money lent by one party to another to be returned normally
with interest. It is a liability of the holding public and asset for the lender/lending
institution. Finance is monetary resources for funding any activity. It consists of debt and
ownership funds of an economic entity.
The financial system of any country typically comprises of financial institutions,

financial markets, and financial instruments and services.
I Financial Institutions are like business organizations involved in the sale-

purchase of financial assets and providing various financial services to the community.
These can be classified on the basis of functions, geographical coverage, sector, scope of
activity or type of ownership. An important classification is that between intermediaries
and non-intermediaries.
Intermediaries are the ones that mediate between those with budget surpluses and
those who wish to run deficits. They buy primary securities and sell secondary securities
that are in general far more acceptable to the surplus units. By transforming primary into
secondary securities they embody innovations in financial technology whereby separate
asset-debt preferences of lenders and borrowers are reconciled to the satisfaction of both

parties. Lenders get access to a wide variety of secondary securities with lower risk,
greater liquidity, lower associated transaction and information costs and a host of other
services. Borrowers are benefited by availability of large pool of funds with greater
certainty and relatively low rates of interest.
An important question that comes to mind is how these intermediaries are able to
offer the low risk secondary securities when they buy primary securities that are more
risky. The answer lies in the law of large numbers, portfolio diversification, and services
of professional management – all these become realizable only when operating on a large
scale.
Intermediaries themselves can be further classified as bank (RBI, commercial

banks, co-operative banks) and non-bank financial intermediaries (NBFIs). The
distinguishing character of the banking mechanism lies in that –
1. They participate in economy’s payment mechanism i.e. provide transaction

services.
2. Their deposit liabilities constitute a major part of economy’s money supply.
3. They can create deposits or credit, which is money.
Many non-banking institutions like LIC, UTI also act as intermediaries and are
known as NBFIs. An important distinction between banks and NBFIs is that banks are
subject to legal reserve requirements. They can advance credit by creating claims
against themselves, while NBFIs can only lend out of resources put at their disposal by
savers.
The non-intermediary institutions like IDBI, NABARD do the loan business but
their funds are not directly obtained from the savers. These have come into existence
because of governmental efforts to provide assistance for specific purposes, sectors and
regions. They are therefore also called non-banking statutory financial organizations
(NBSFOs).
II Financial Markets are a significant component of any financial system. These

refer to the institutions or arrangements that facilitate the transactions in financial assets

and credit instruments of different types as currency, cheques, bonds etc. The market
may not have a precise physical location. The participants on the demand and supply
sides of these markets are financial institutions, agents, brokers, dealers, borrowers,
lenders, savers etc. These markets can be classified in a variety of ways.
A. Based on maturity structure, we can talk of money market and capital-market.

Money market is a source of short-term funds (one year or less). It facilitates
adjustment of liquidity amongst its participants. Examples: bill market, inter-bank
call money market, working capital advances from commercial banks etc. Capital
Markets deal in long-term and medium term claims. Examples: Stock market,
government bonds market, financial institution credit. For long and medium term
claims the maturity is more than a year but in a well-developed financial system
secondary markets exist for most of such claims thus making them fairly liquid.
B. Based on type of securities traded: primary and secondary market. Primary market
or new issues markets deal in new financial claims. Secondary markets deal in
securities already issued. Although secondary markets do not contribute directly
to the supply of additional capital, they do so indirectly by increasing the liquidity
of primary securities.
C. According to the nature of instruments traded, these markets can be classified as
debt, equity, or financial service markets. Debt market is where lenders provide
funds to borrowers for some specified period at fixed interest rate. In equity
market, ownership of tangible assets (such as houses or share of stock) is brought
and sold. Financial services markets deal in services that enhance the working of
debt and equity markets. Examples: safety deposit boxes, ATM transactions,
brokerage services etc. No secondary market exists for financial services.
D. Organized and Unorganized markets – When financial transactions take place
outside well-established exchanges or without systematic and orderly structure, in
an informal way - it constitutes the unorganized markets. It is largely made up of
indigenous banks, moneylenders, and activities not coordinated by RBI or any

other authority. The formal sector constitutes the organized segment. It is subject
to different types of regulations from the authorities from time to time.
III Financial Instruments and Services: The financial claims or instruments and
services are many and varied in character because of diversity of motives behind
borrowing and lending. Indeed the maturity and sophistication of a financial system is
often gauged by the prevalence of a wide variety of assets and services to suit varied
investment requirements of heterogeneous investors. This enables them to mobilize
savings from as wide section of investing public as possible. Financial securities can be
classified as primary (direct) and secondary (indirect) securities. Primary securities are
financial claims against real sector units e.g. bonds, equities, bills etc. – i.e. backed by
real investments. Secondary securities are claims issued by financial institutions against
themselves to raise funds from public e.g. currency, bank deposits, insurance policies,
post office deposits etc.
ROLE OF FINANCE IN ECONOMIC GROWTH
The relationship between finance and economic development is a long debated

issue. There is a long list of economists who stress the importance of a sound financial
system for economic growth. Schumpeter1, the first modern economist to study the
relationship regarded banking system as one of the two ingredients in the process of
development. Gerschenkron2 considers that banking sector plays a key role at certain
stages of industrialization process. Goldsmith finds a positive relation between economic
development and financial development. McKinnon, Shaw, Greenwood, Jovanovic,
Levine, Allen, Gale all reiterate this view3. These economists thus suggest a ‘supply-
1
Schumpeter,J.A.(1911). The Theory of Economic Development. Cambridge,MA: Harverd
University Press.
2
Gerschenkron,A.(1962). Economic Backwardness in Historical Perspective. A Book of Essays,
Cambridge,MA Harverd University Press.
3
Refer chapter 3 for a detailed literature survey

leading’ financial development i.e. financial development precedes economic

development; brought about through a conscious, deliberate policy by the authorities.
The basic idea behind such promoted financial development is that it will help to
accelerate the real rate of growth. The available literature points to a number of channels
through which finance promotes growth:
 Increasing savings rate and therefore investment.

 Investment allocation
 Technical innovations
 Easing external financing constraints
 Improving corporate governance
 Reducing credit rationing
EVOLUTION OF THE INDIAN FINANCIAL SYSTEM
Pre-Independence: The Indian financial system, on the eve of planning, was

immature and partially rudimentary reflecting the underdeveloped state of the economy.
Some sort of banking business had begun during the early part of the 19th century, but it
experienced little growth that too in the early part of 20th century. It was concentrated in
the hands of a few large banks, though qualitatively, the services of small banks were of
great importance. Most popular form of bank credit was cash credit and overdrafts. Bill
finance was not much prevalent. The indigenous bankers dominated the financial scene.
They financed trade, acted as government bankers, mint-managers, and moneychangers,
and managed transfer of funds. Although co-operative banking began during 1920s, it
made little progress, particularly in relation to demand for funds in the agricultural sector.
Post offices saving bank deposits and small saving certificates have been one of the
oldest mediums for community savings. Life insurance business on sound lines began in
the second decade of the 20th Century.

The first stock exchange was established in 1887. The increased pace of
industrialization due to two world wars, protection to domestic industries in fiscal
measures, resulted in active new issue markets and stock exchanges. The practice of
companies accepting deposits directly from the public was well developed even before
1950. The market for government securities and treasury bills had also expanded
phenomenally before 1950. The price of government securities showed significant
fluctuations before 1935. The setting up of the Reserve Bank of India (RBI) in 1935
facilitated the pursuit of policy of stable government security prices after that year. There
were wide inter-bank and inter-regional differences in the rates of interest. Compared to
the position after 1950, the level of interest rate even in the organized sector during major
part of the period before 1950 was quite high. They declined only after 1933 and then
were maintained at relatively low levels.
Post Independence: With the initiation of planned economic development in

1951, the Indian financial System entered a new phase of development.
Organization: The heavy industrialization strategy with a major role to the public
sector greatly conditioned the evolution of the financial system in the independent India.
It had a significant bearing on the institutional structure and regulatory framework.
Public control was extended over financial institutions partly through nationalization of
existing institutions but mainly through establishment of new institutions in the public
sector – the development financial institutions and unit trusts that dominated the Indian
financial system for quite some time. To ensure that private industry operated on the
desired path laid down by the five-year plans; restrictions were imposed on investment
institutions governing their investments in the private sector. Public sector financial
institutions participated in the management and control of enterprises to which finance
was provided.
A BRIEF OUTLINE OF THE PROPOSED STUDY
The study analyses the reforms relating to the financial sector undertaken in 1991
with a view to assess their impact on the economic growth of India. The study has first

examined the extent of financial development that has taken place subsequent to the
reforms. It has compared the pre and post–reform period on the basis of a number of
indicators so as to give a comprehensive impact of these reforms. It has then examined
the extent to which the resulting financial development has influenced the economic
growth in India.
Thus, the study is organized in two parts:
 Impact of financial sector reforms on the development of Indian Financial

System, and
 The FD-EG nexus for India.
Objectives
The work is a comparative study of pre and post liberalization period. It aims to
achieve the following objectives:
 To study the reforms taken place in the financial sector.

 To find the impact of these reforms on financial development in terms of different
indicators for density, deposits and credit making functions.
 To assess the impact of reforms on the financial performance of financial
institutions.
 To assess the impact on size, liquidity, and volatility of the stock market.
 To examine the relationship between financial development and economic growth
in India.
In the light of above objectives the study has examined the following:
1. In the post-liberalization period (as compared to the pre-liberalization period).

a. Financial deepening has taken place.
b. Deposits and institutional credit have significantly increased.
c. Savings and investment have increased at much higher rates.
d. Competition in the financial sector has substantially increased.

e. Performance in terms of profits and productivity of the financial sector has

improved.
f. Size and liquidity of the stock market has shown improvement.
2. There exist a significant positive relation between institutional credit to the private
sector and rate of growth of the Indian economy.
3. There exist a significant positive relation between stock market indicators and
economic growth in India.
4. The contribution of financial development to economic growth in India through
increased investment is substantial.
The time period used in above analyses is 1950-51 to 2006-07. In cases where
data is not available for the entire time period, different sub-periods are used for which
the relevant data is available.
FINANCIAL SECTOR REFORMS
When India became independent in 1947, it was a backward, primarily agrarian,

stagnant, and low-income economy. Institutional set up and infrastructure was terribly
weak. We started with a centrally planned process of economic development but the
progress for a period of over four decades had been far from satisfactory. Whether
looked at from an economic angle or a social view point there were problems of various
kinds. On the whole, slow and uneven progress had taken place. In the beginning of
1990s India was faced with serious fiscal and financial problems. It had to approach the
World Bank and other international financial institutions for financial assistance. It was
against this backdrop, that wide-ranging reforms, encompassing all sectors of the
economy were initiated. This chapter outlines the need for reforms in the financial sector
and presents a summary of these reforms.

NEED FOR REFORMS
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
had a pre-dominant role in economic activity. In order to facilitate the large borrowing
requirements of government, SLR was frequently revised upwards and maintained at high
levels. Interest rates on government securities were artificially too low, unrelated to the
market conditions. The government securities market could not develop. The provision of
fiscal accommodation through adhoc treasury bills (at 4.6%) led to high levels of
monetization of fiscal deficit. To check the monetary effects, CRR was frequently
revised upwards. The CRR and SLR on the eve of the reforms were quite high and the
associated interest rates low.4 The environment in the financial sector in those years was
characterized by segmented and under developed financial markets with paucity of
instruments.
The existence of a complex structure of interest rates arising from economic and
social concerns of providing concessional credit to certain sectors had resulted in cross
subsidization which implied that higher rates were charged to non-concessional
borrowers. The regulation of lending rates led to the regulation of deposit rates to keep
the cost of funds to banks at reasonable levels. The system of administered rates had led
to multiplicity and complexity of interest rates. On the whole the directed and
concessional availability of bank credit with respect to certain sectors resulted in
distorting the interest rate mechanism and adversely affected the viability and
profitability of the banks. Lack of recognition of the importance of transparency,
accountability, and prudential norms in the operations of banking system led to a rising
burden of non-performing assets.
The policies pursued did have many benefits. The post nationalization phase
witnessed significant branch expansion to mobilize savings. There was visible increase
4
The CRR in 1991 was 15% with an additional incremental requirement of 10%. The SLR in 1991 was
38.5%. The government therefore mopped up 63.5% of the banking deposits in 1991.

in the flow of bank credit to important sectors like agriculture, small-scale industries, and
exports. These achievements however, have to be viewed against gross inefficiencies at
the micro level.
THE REFORMS OF 1991 (NCR-I)
On the whole, banks, other financial institutions, and financial markets were all
operating in a highly controlled and regulated environment. Some steps towards
liberalization were taken during 1980s. In 1991, wide ranging economy wide reforms
were undertaken. In August 1991 the government of India appointed a committee on the
financial system under the chairmanship of Shri M.Narasimham, a former governor of the
RBI. The Committee was to examine the existing structure of the financial system and its
various components and to make recommendations for improving the efficiency and
effectiveness of the system with particular reference to the economy of operations,
accountability and profitability of the commercial banks and financial institutions5.
The committee’s approach to the issue of the financial sector reform was to
ensure that the financial services industry operates on the basis of the operational
flexibility and functional autonomy with a view to enhancing efficiency, productivity,
and profitability. A vibrant and competitive financial system was seen as necessary to
sustain the ongoing reform in the structural aspects of real economy. The committee was
of the view that Indian banking and financial system had made commendable progress in
extending its geographical spread and functional reach and that there had been
considerable diversification of money and capital markets. Despite this progress, however
certain serious problems had emerged reflected in a decline in productivity and efficiency
and erosion of the profitability of the banking sector. The two major factors identified
were directed investments and directed credit programmes, both earning a much lower
rate of interest than the market rate. Among the other important factors noted were the
deterioration in the quality of loan portfolio, increasing expenses due to massive branch
5
Report of the Committee on the Financial System – A Summary, RBI Bulletin, Feb, 1992.

expansion many of which were unremunerative, specially in rural areas, over manning,
inadequate technical progress, weaknesses in internal organization structure, excessive
political interference etc.
Following were the major re-commendations:
SLR to be brought down is a phased manner to 25% over a period of 5 years. It

should not be viewed as a major instrument for financing the public sector.
CRR should be progressively reduced. RBI should have the flexibility to operate
this instrument to serve its monetary policy objectives rather than to control the
secondary expansion of credit.
THE SECOND GENERATION REFORMS 1998 (NCR-II)
In the first phase of reforms as discussed above the focus had been on arresting
the qualitative deterioration in the functioning of the system. Most of the
recommendations were promptly implemented and a measure of success achieved. In the
meanwhile, major changes had been taking place in the domestic economic and
institutional scene, coinciding with the movement towards global integration of financial
services. These developments re-enforced the importance of building a strong and
efficient financial system. In 1998, therefore, the situation was reviewed and there were
the second-generation reforms. These could be looked at in terms of 3 broad inter related
issues:
 Actions that need to be taken to strengthen the foundations of the banking system
 Streamlining procedures, upgrading technology and human resource
development, and
 Structural changes in the system.
The major recommendations included increase in CRAR to 10% by 2002, new

guidelines for asset classification, reduction in net NPAs to below 3% (0% for those
banks with international presence), elimination of subsidy element in priority sector
(redefined) lending, full disclosure of information, revised and regularly updated

operational manual by banks and consolidation and convergence of the financial system,
a system for recruiting skilled manpower from the open market, re-deployment of surplus
staff, flexibility to determine managerial remuneration, achieving rapid induction of
information technology, allowing foreign banks to set up subsidiaries or joint ventures in
India, evolution of a risk management system, greater internal controls, transparency and
market discipline, legislative steps etc.
The government’s responsibility as per the committee would then be to create and
nurture a diversified and functionally efficient financial system through an appropriate
incentive framework and a legal system rather than through direct interventionalist
policies.
Review of Literature
DIFFERENT VIEWS IN LITERATURE
The reforms of the financial sector affect economic growth through the finance
growth linkages. The relationship between financial development and economic growth
is a long debated issue. Schumpeter (1911), the first modern economist to study the
relationship regarded the banking system as one of the two key ingredients in the process
of development. He argued that the services provided by financial intermediaries -
mobilizing savings, evaluating projects, managing risk, monitoring managers and
facilitating transactions – are essential for technological innovation and economic
development. Gerschenkron (1962) considered that the banking system does play a key
role at certain stages of the industrialization process. He viewed industrialization as a
process that spread from its birthplace in England to ‘more backward’ countries.
Goldsmith’s (1969) pioneering study to assess whether finance exerts a causal

influence on growth found a positive relation between economic growth and financial
development. Economic growth according to him is a complex phenomenon determined

by a number of factors – physical, technical, economic, and mass psychological in nature.

He identified the following measures of financial structure:
- Financial inter-relationship ratio: This is the ratio of total value of all financial
assets at a date by total value of tangible assets plus net foreign balance i.e. by
national wealth. Thus, this gives a relation between a country’s financial
superstructure and its real infrastructure.
- Composition of financial super structure reflected in distribution of total
financial liabilities and assets among their main types, and distribution of
financial assets among main sectors and sub-sectors.
- Relative importance of different types of financial institutions.
- Degree of institutionalization of financial structure reflected by share of
financial institutions in the total stock of financial assets.
He used the financial inter-relationship ratio (FIR) as the single main

characteristic of level of a country’s financial development. Based on data from 35
countries, he found that developed countries had higher FIR than less developed ones -
the association being loose and irregular. R2 obtained was 0.19 i.e. approximately one-
fifth of inter-country variations in FIR being explained by the differences in real per
capita GNP. He attributed this co-relation to the positive effect that financial
development has in encouraging more efficient allocation of capital expenditures among
and within sectors, types of tangible assets and regions. He contended that both economic
theory and economic history assure that the existence and development of financial
superstructure is a necessary though not sufficient condition for economic growth and
both point out that relationship between economic growth and financial development is
complicated and not easily amenable to generalizations. He argued that the process of
economic growth has feedback effects on financial markets by creating incentives for

further financial development. Thus both growth and financial intermediation are
thought of as endogenous.
THE STUDIES FOR INDIAN ECONOMY
In case of Indian Economy, data on extensive set of measures of economic

performance and financial indicators is available for a much longer time span than
commonly used in studies of sets of countries. Another salient advantage of focusing
exclusively on one country is that the econometric finding can be related to the prevailing
institutional structure. There exist a number of studies that have tried to analyze the
impact of financial liberalization on economic growth of India. Some studies focus on the
impact of the liberalization on the productivity performance of the financial sector.
Demetriades and Luintal (1996, 97) have examined the effects of various
banking sector controls prior to liberalization on financial deepening using RBI data.
They found that all controls except lending rate ceiling are negatively associated with
financial development. Financial repression has substantial (adverse) direct effects on
financial deepening, independent of its influence through rate of interest. Exogeneity
tests suggest that financial development and economic growth are jointly determined.
Thus polices which affect financial development may also affect economic growth.
Bhattacharya, et al (1997) studied the impact of increased competition due to

limited liberalization initiated before the deregulation of nineties on performance of
different categories of banks, using Data Envelopment Analyses for the period 1986 to
1991 for 70 banks. They found that public sector banks had highest efficiency. However,
after 1987 efficiency of public sector banks (PSBs) declined, that of private banks
showed no change and that of foreign banks increased. In a review of competition of
banking sector in the deregulation period RBI (1999a) noted that development after 1996

indicate that a majority of PSBs have been able to progress considerably towards the
direction of passing the acid test of achieving competitive efficiency.
Financial Development In India: Pre And Post Liberalization
FINANCIAL DEVELOPMENT: QUALITATIVE ASPECTS AND QUANTITATIVE

DIMENSIONS
A financial system operates through financial institutions and markets. These

deal in financial assets and instruments of various kinds as currency, deposits, bills,
bonds etc. Any development of the financial system therefore involves significant
changes of quantitative and qualitative nature in financial institutions, markets and
securities; changes of the kind that would help the financial system serve its basic
functions of increasing savings and investment in the economy and allocating available
funds in the best possible manner.
Financial development thus is a broad concept incorporating a number of

quantitative and qualitative changes in the financial system6. As financial system
develops, various kinds of financial institutions, markets and instruments increase
substantially in the economy. This is to say, the depth of the financial system increases.
The institutions become geographically widespread. More and more areas and therefore
population is able to have access to their services. There is emergence and development
of a strong, active large sized non-bank financial sector comprising of stock market, debt
market, insurance companies, pension funds, mutual funds etc. With coming up of a wide
6
For a succinct discussion of the concept see Bhole, L.M. (2004) : Financial Institutions
and Markets : Structure, Growth and Innovations, Tata, Mc Graw Hill.

variety of new financial institutions and markets, the range of assets available for
mopping the surplus funds in the economy substantially increase. This greatly
encourages more and more of surplus funds to move to productive uses via the financial
sector. Secondary market is well developed in all securities. This greatly increases the
liquidity of these securities and makes them more attractive for the investor.
Financial development usually involves upcoming of a number of private sector

(including foreign) banks and other financial institutions. Public sector becomes less
important. With the private sector coming in, there is enough competition and
inefficiency is penalized. New improved practices and methods develop; improved ways
of functioning e.g. computerization become prominent. With all this, time, energy and
money costs of transactions and the information costs are greatly reduced. The
institutions and markets become more and more efficient in their functioning and rate of
interest becomes market determined. The financial institutions have specialized staff to
look into profitability and productivity aspects of different business proposals and
accordingly disburse credit. These also often provide them guidance and specialized
services. There is strong and effective system of supervision, inspection, auditing and
regulation with financial organization conforming to international standards with respect
to capital adequacy, non-performing assets etc. With all these, the financial system is
greatly able to increase savings and investment in the economy and allocate the available
funds to most productive uses.
INDICATORS OF FINANCIAL DEVELOPMENT
The study now examines what has been the nature and extent of financial
development in India and in what ways has it been affected by the liberalization process.
In this chapter, the focus is on financial institutions. Financial markets are studied in a
separate chapter later.

The financial development in independent India has been determined by the

nature of our mixed economic system. On the whole over a period of more than half a
century, the Indian financial system has shown remarkable progress, both in quantitative
and qualitative terms. The number and density of banks and other financial institutions
has greatly increased; new and new markets have continuously come up. The number
and types of financial securities now available is huge as compared to 60 years ago. The
entry of a number of private and foreign banks have made for strong competitive
pressures in the financial sector so that is has become more efficient in its functioning.
Non-performing assets now are substantially lower than before and capital adequacy ratio
much higher. Computerization and e-transactions has become widespread, savings and
investment in the economy, bank deposits, and credit, primary and secondary issues, have
all increased tremendously, only a part of the increase being explained by inflation. This
quantitative growth has been accompanied by significant diversification and innovations
in respect of an array of financial institutions, instruments and services. Also significant
reorganization, globalization, privatization, deregulation, automation, consolidation, and
merger of financial institutions have been affected.
In order to see the impact of financial sector reforms on the development of the
financial system it is required to make a comparative study of the development prior to
reforms and after the reforms. This is done based on a number of indicators; time period
for each of them has been indicated along with.
Gross Domestic Savings and Investment
The extent of development of the financial system best manifests itself in the
success of its basic functions i.e. to what extent the financial system has been able to tap
the surplus funds available in the economy and channel them into productive
investments.

Savings
Savings in India are done by the households, the businesses (i.e. the private
corporate sector), and the government. Of these sectors, the dominant saver in India is the
household sector followed by the private corporate sector. The contribution of public
sector to total domestic savings is small, lately negative7. Both public sector and private
corporate sector are net deficit spenders who draw upon the savings of the household
sector. The household sector also borrows from other sectors (banks, term lending
institutions etc.) but its savings far exceed the borrowings 8. So effectively, household is
the only surplus sector in the economy. It is a major task of the financial system to
increase this surplus and make more and more of it available for productive investment in
the economy.
Savers (households) require stores of value to hold their savings. The financial
system promotes savings by providing a wide variety of financial assets, together with
numerous services of financial markets and financial intermediaries. With financial
progress and innovations in technology, scope of portfolio choice has greatly improved.
Lots of combinations of risk and return have become available so that people in general
tend to save more.
Financial progress generally induces larger savings out of the same level of
income. More and more of these savings are in the form of financial assets as currency,
deposits, insurance policies, bonds etc. rather than physical assets like gold or real estate.
These assets are easy to store and manage, less risky and more liquid than most tangible
7
See table 4.1.
8
table 4.2 below.

assets. Thus, out of given savings, the proportion of financial assets (excluding currency)
increase. This is financialization of household savings.
Financial assets separate the act of savings from the act of real investment.
Mobilization of savings takes place when people move into financial assets. They buy
assets like bank deposits, insurance policies etc. from financial institutions9 thereby
entrusting their savings to them who allocate it further among competing borrowers. This
represents financial intermediation or institutionalization of savings i.e. going to
borrowers through institutions rather than directly via primary securities.
So the savings in India are done majorly by the households and in small amounts
by the private corporate sector and the government. Of these it is only the savings of the
household sector whose magnitude is affected by the changes in the financial system. In
order to assess the extent of financial development, it is therefore more informative to
look at savings of the household sector, their financialization and institutionalization. As
financial sector develops, much more facilities and opportunities are available for
deployment of surplus funds. So people tend to save more, more of such savings are in
financial rather than physical assets and more and more of financial assets are held with
institutions rather than privately or as currency with individuals themselves or in primary
securities.
Investment
The terms refers to the act of purchasing tangible (real) assets for the purpose of
utilizing them in productive activity. Besides this fixed investment change in stocks10 is
also a part of investment. Investment can be either gross investment or net investment,
9
These are secondary securities as against primary securities issued by ultimate borrowers like bonds,
company deposits etc.
10
stocks may be of finished goods, semi-finished goods, or raw materials.

the difference between the two being consumption of fixed capital. Although the net
values give a true measure of the addition to the productive capacity of an economy, it is
common to use gross values for various analytical purposes due to arbitrariness in
calculation of depreciation. Investment too like savings, is done both by the private and
the public sectors, only private sector investment being responsive to development, or
otherwise of the financial system.
Aggregate savings (i.e. domestic availability of funds) and investment determine

the need for foreign funds and also success or otherwise of the financial system to
effectively mobilize the available funds to productive channels.
Deposits
An important task of the financial system is to collect the funds available with the
surplus sector. Success of any financial system depends on how much of the surplus it is
able to mop up in the first place. Deposits are moneys accepted by various agencies from
others to be held under stipulated terms and conditions. In India, banks, post offices11,
and non-bank companies accept deposits.
Bank deposits
Deposits constitute a major source of funds for banks. Bank deposits can be
further classified on the basis of whether they are made in commercial banks, co-
operative banks, and scheduled or non-scheduled banks. For a proper classification, we
therefore need to bring in the structure of the Indian Banking System.
11
For post office deposits see Gupta, S.B.(1999), Monetary Economics: Institutions Theory And Policy,
S.Chand, India.

Indian Banking System
As an apex institution of the Indian banking system is the Reserve Bank of India
(RBI). It is a regulatory body and does not directly accept deposits from public.
Deposits are accepted by commercial and co-operative banks, scheduled and non-
scheduled.
Reserve Bank Of
India
Scheduled Banks Non-scheduled

Banks
State Commercial Central Commerci

Coop. Coop. Banks al
Banks
Banks and Primary
Banks
Credit
Societies

TRENDS IN FINANCIAL DEVELOPMENT
This section gives the empirical results of the comparative study of pre and post
liberalization period with respect to the indicators of financial development discussed in
section 4.2 above.
Gross Domestic Savings and Investment
Data on savings and investment is presented in table 4.1
Gross Domestic Savings And Capital Formation

As Percent Of GDP At Current Market Prices
Gross Domestic Capital
Gross Domestic Saving
Formation
Household Private Private

Year Public sector Total Public sector Total
sector corporate sector sector
1950-51 5.73 0.92 1.95 8.6 2.9 7.37 8.4
1951-52 5.09 1.27 2.64 9 3.2 7.43 10.7
1952-53 5.69 0.61 1.7 8 2.8 5.84 7.7
1953-54 5.38 0.79 1.43 7.6 2.9 4.28 7.5
1954-55 6.19 1.09 1.82 9.1 4.7 5.08 9.3
1955-56 8.98 1.21 2.11 12.3 5.1 7.2 12.6
1956-57 8.43 1.18 2.29 11.9 5.6 8.66 14.6
1957-58 6.8 0.89 2.31 10 6.7 7.77 13.5
1958-59 6.19 0.93 1.98 9.1 6 5.54 11.6
1959-60 7.58 1.16 2.06 10.8 6.3 6.9 12.3

1960-61 6.53 1.61 3.06 11.2 7.2 7.19 14
1961-62 6.2 1.73 3.27 11.2 6.9 7.85 13.1
1962-63 7.03 1.74 3.53 12.3 8 7.43 14.5
1963-64 6.32 1.73 3.85 11.9 8.1 7.15 13.8
1964-65 6.34 1.46 3.8 11.6 8.1 7.28 13.8
1965-66 8.6 1.45 3.65 13.7 8.7 7.43 15.8
1966-67 9.52 1.34 2.74 13.6 7.5 8.91 16.6
1968-69 7.94 1.12 2.74 11.8 6.2 8.01 12.9
1969-70 9.73 1.27 3 14 5.8 9.27 14.5
1970-71 9.45 1.45 3.3 14.2 6.7 8.88 15.1
1971-72 9.93 1.55 3.22 14.7 7.3 9.38 15.7
1972-73 9.64 1.48 3.18 14.3 7.6 8.37 14.8
1973-74 11.43 1.63 3.34 16.4 7.8 8.63 17
1974-75 9.78 1.87 4.05 15.7 7.8 10.38 16.5
1975-76 10.88 1.29 4.73 16.9 9.8 9.01 16.7
1976-77 12.37 1.3 5.43 19.1 10.3 8.6 17.6
1977-78 13.25 1.37 4.88 19.5 8.5 10.02 18
1978-79 14.64 1.48 5.08 21.2 9.7 10.82 21.3
1979-80 12.96 1.96 4.88 19.8 10.6 10.65 20.3
1980-81 12.88 1.61 4.01 18.5 8.9 9.61 19.9
1981-82 11.51 1.5 5.09 18.1 10.6 11.6 19.6
1982-83 11.11 1.56 5.03 17.7 11.3 10.15 19
1983-84 11.74 1.46 3.9 17.1 10.3 9.24 18.3

1984-85 13.11 1.62 3.47 18.2 11 10.37 19.6
1985-86 13.13 1.93 3.94 19 11.4 12.07 21.2
1986-87 13.23 1.69 3.48 18.4 11.8 11.19 20.5
Contd …
Gross Domestic Capital
Gross Domestic Saving Formation
Household Private Private Total

Year Public sector Total Public sector
sector corporate sector sector *
1987-88 15.62 1.66 2.92 20.2 10.2 11.84 22.1
1988-89 15.76 2 2.74 20.5 10.2 13.48 23.4
1989-90 16.97 2.43 2.4 21.8 10.2 13.53 24.3
1990-91 18.4 2.66 1.74 22.8 10 14.17 26
1991-92 15.81 3.1 2.59 21.5 9.5 12.5 22.1
1992-93 16.39 2.65 2.16 21.2 9.1 14.67 23.1
1993-94 17.27 3.45 1.18 21.9 8.8 12.45 22.5
1994-95 18.59 3.47 2.34 24.4 9.3 14.2 25.5
1995-96 16.87 4.96 2.57 24.4 8.2 18.39 26.2
1996-97 16.03 4.51 2.16 22.7 7.5 14.64 24
1997-98 17.7 4.31 1.79 23.8 7.1 16.84 25.3
1998-99 18.83 3.93 -0.46 22.3 7 15.62 23.3
1999-00 21.13 4.47 -0.8 24.8 7.4 17.9 25.9
2000-01 21.6 3.9 -1.8 23.7 6.9 16.6 24.3
2001-02 22.1 3.4 -2 23.5 6.9 16.7 22.9

2002-03 23.2 3.9 -0.7 26.4 6.1 18.6 25.2
2003-04 24.4 4.4 0.9 29.7 6.3 19.5 28.2
2004-05 23 6.6 2.2 31.8 6.9 23.4 32.2
2005-06 24.2 7.5 2.6 34.3 7.6 25.8 35.5
2006-07 23.8 7.8 3.2 34.8 7.8 27 35.9
* Total capital formation includes valuables and errors and omissions apart from capital
formation by the public and the private sector
It shows Gross Domestic savings and Gross Domestic Capital Formation from
1950-1951 to 2006-07. The magnitudes are shown as percentage to GDP at current
market prices. The data has been obtained from the latest Economic Survey and the
Handbook of statistics on The Indian Economy. The table separately gives the
contribution of the household sector, the private corporate sector, and the public sector to
the total savings in India. It can be seen from the table that the dominant saver in India is
the household sector followed by the private corporate sector. The contribution of public
sector to total domestic savings is small, lately negative. Chart 4.1 below illustrates the
trends in household sector savings and gross domestic savings as percentage of GDP at
current market prices.
Savings As Percentage Of GDP

40
35
30
25
percent
20
15
10
HH savings as% of GDPmp GDS savings as% of GDPmp
From the chart 4.1, it can be seen that in the case of savings of the household
sector, there is a noticeable up trend in the years after mid 1990s. For total savings the
noticeable increase in the rate occurs somewhat later but is more marked than in case of
household savings.
The results of regression analyses for structural break12 corresponding to the

reforms suggest that the rate of growth of both household and total savings have
significantly increased after the reforms. The relevant regression equations are:
GDS = 15.03 + 0.335T; r2 = 0.91;df = 41; tcal = 20.21; t41 = 2.7 (1)
GDS = 25.68 + 0.796T; r2 = 0.64; df = 12; tcal = 4.43; t12 = 3.05 (2)
12
Dummy variables provide an alternative approach to test for structural breaks. See
Gujarati, D (1988), Basic Econometrics 2nd ed. Mc-Graw Hill.

Fcal = 13.36 > F2,53 = 5.05 (level of significance 1%)
(1) above represents the best fit for the period prior to the reforms, and
(2) represents the position after the reforms.
For household savings, the regression equations are:
HH Sav = 10.29 + 0.27T; r2 = 0.87;df = 41; tcal = 16.78; t41 = 2.7 (1)
HH Sav = 19.98 + 0.57T; r2 = 0.76; df = 12; tcal = 5.99; t12 = 3.05 (2)
(1) above represents the best fit for the period prior to the reforms, and
These equations clearly show that the average annual rate of growth, given by the
estimated value of the parameter b, has more than doubled in the post-reform period both
for aggregate domestic savings and the household savings. The associated t-values are
greater than the critical values obtained from the tables in all cases (at 1% level of
significance)13. This implies that the estimated growth rates are statistically significant in
all cases. The F test is rejected in both cases thus indicating a structural break
corresponding to the reforms. This implies that in the period after 1992-93 the average
annual rates of growth of both aggregate domestic savings and the household savings
13
and all significance levels more than 1%. In fact the obtained t-values are high enough to reject the null
hypotheses even at 0%.

have substantially increased and that this increase is statistically significant. One
qualification needs to be considered here. The observed increases in growth rates in the
period after 1992-93 would also contain the effect of a number of other changes going on
in the economy after the economic reforms of 1991. However one can reasonably expect
that in case of financial variables the predominant effects would be those of changes
taking place due to reforms of the financial sector. In any case the magnitude of change is
substantial in both cases so that even after allowing for some impact of other factors a
huge margin remains that can be attributed to the financial sector reforms.
As for capital formation the table 4.1 above gives the contribution of the public
and the private sector separately. It is apparent that the contribution of the private sector
was more than that of the public sector even in the years before the reforms. After the
reforms the differential has substantially increased. Private capital formation has
increased much faster than the total. Chart 4.2 below illustrates these investment trends.
Investment As Percentage Of GDP
40
35
30
25
percent
20
15
10
GDCF(pvt) as% of GDPmp GDCF as% of GDPmp

Both the curves in chart 4.2 are steeper after the early 1990s than before that.
This indicates an increase in the rate of growth after the reforms. The gap between the
two curves representing capital formation by the public sector can be seen to have
declined consistently since the early nineties.
The regression equations for the trends in investment are as follows:
GDCF = 16.35 + 0.34T; r2 = 0.89; df = 41; tcal = 18.65; t41 = 2.4 … (1)
GDCF = 26.23+ 0.65T; r2 = 0.46; df = 12; tcal = 3.05; t12 = 2.7 … (2)
As before (1) above represents the best fit for the period prior to the reforms, and
The equations in case of private capital formation are:
GDCF(pvt) = 9.15 + 0.174T; r2 = 0.816; df = 41; tcal = 13.52; t41 = 2.4 (1)
GDCF(pvt) = 17.34+ 0.64T; r2 = 0.7; df = 12; tcal = 5.12; t12 = 2.7 (2)

PERFORMANCE OF THE INDIAN FINANCIAL SECTOR
It has been noted in the previous chapter that substantial development of the
financial sector has taken place subsequent to the reforms. It now remains to examine the
financial health of the constituents of this sector. The performance of the sector in terms
of levels of profitability, non-performing assets, capital adequacy ratio, and various
indicators of efficiency and productivity has been examined in the sections that follow.
Before evaluating the performance the chapter gives a brief overview of the progress in
the financial sector prior to liberalization and the major focus of the reforms.
THE PROGRESS PRE-LIBERALIZATION
Ever since nationalization, the Indian banking and financial system had made
commendable progress in extending its geographical spread and functional reach. The
spread of the banking system had been a major factor in promoting financial
intermediation in the economy and in the growth of financial savings from all parts of the
country. Besides mobilizing savings on a large scale, nationalized banks were able to pay
attention to the credit needs of weaker sections, artisans and self-employed.
Bank nationalization1 however created its share of problems too: excessive

bureaucratization, red tapism, disruptive tactics of trade unions of bank employees etc.
Nationalization resulted in RBI enforcing uniform interest rates and service charges
among banks. This caused a lack of competition and gradually eroded the spirit of
competition from the banking sector. This combined with the labor policies where
employees’ salaries and promotions were not linked to their performance led to a steady
decline in efficiency, quality of customer service, and work culture in banks. Moreover,
due to directed lending at concessional rates and other statutory requirements like CRR,
1
For pros and cons associated with nationalization refer Patel, I.G., (2003) Glimpses Of Indian Economic
Policy, Oxford University Press, Oxford.

SLR etc. only around one-fourths of total loanable funds with banks were available for
meeting the financial needs of rest of the economy.
With time the development financial institutions had established themselves as

major institutional support for investment in the private sector. Over the last two and half
decades, more so since the early nineties there has been considerable diversification of
the money and capital markets. New financial services and instruments have appeared on
the scene.
FINANCIAL SECTOR REFORMS: THE FOCUS
The (Narasimham) Committee on financial sector reforms took due note of the
progress in terms of quantitative parameters as increased savings (especially financial
savings) and investment, higher deposit mobilization and greater credit reach and
disbursement etc. as also of quantitative and qualitative changes in the structure of the
financial system. It did, however, stress on the fact that ‘despite this commendable
progress serious problems had emerged reflected in a decline in productivity and
efficiency and erosion of the profitability of the banking sector 2… the accounting and
disclosure practices also do not always reflect the true state of affairs of banks and
financial institutions...’ Both banks and DFIs3 have suffered from excessive
administrative and political interference in individual credit decision-making and internal
management. The committee’s focus therefore was to ‘ensure that the financial services
industry operates on the basis of operational flexibility and functional autonomy with a
view to enhancing efficiency, productivity and profitability’. A vibrant and competitive
financial system was also seen necessary to sustain the ongoing reforms in structural
aspects of the real economy.
2
Report of the Committee on the Financial System – A Summary, RBI Bulletin, Feb, 1992
3
developmental financial institutions.

PERFORMANCE PARAMETERS
The commercial banks themselves form a heterogeneous collection of different

categories of banks. These differ substantially in terms of ownership and consequently in
their performance levels. So4 the performance has been evaluated in aggregate terms for
all SCBs as a group and separately for different categories5. The following parameters
have been examined:
 Operating profit/Total Assets – To examine the profitability of commercial banks

operating profit rather than net profit is used because it is not affected by
exogenous factors as tax rules, etc. Operating profit = net profit + provisions and
contingencies.
 Net Non-performing assets / net advances.
 Capital Adequacy Ratio and proportion of banks above 10%.
 Productivity as measured by - ratio of intermediation costs to total assets,

operating profit to wage bill ratio, and business per employee.
 Competition - In addition to the above parameters inferences about the increase

(or decrease) in competitiveness of the banking sector have also been made.
Most of the data has been obtained from the ‘Statistical Tables Relating To Banks
In India – 1979-2007’.6 This gives annual time series data relating to both balance sheet
4
subject to the limitations imposed by the availability of data
5
The categorizing is different in case of different parameters and is indicated along.
6
Wherever a source other than the one stated is used it has been specifically mentioned.

and profit and loss variables. Data is available in terms of individual banks and in terms
of bank groups and aggregate for all scheduled commercial banks.
The categories of banks groups made are:
i. State Bank and its associates

ii. Nationalized banks
iii. Other scheduled commercial banks
iv. Foreign banks
v. Regional rural banks.
The first two categories comprise the public sector banks. The banks in private
sector (both old and new) are covered in other scheduled banks. The aggregate data for
scheduled commercial banks is given both including and excluding the regional rural
banks (RRBs). Data on public sector banks is available from 1979 to 2006-2007. For the
rest, data up to 1988-89 is not available. This however does not seriously constrain the
analyses in view of the fact that public sector banks constituted more than 90% of the
total banking assets in the pre-reform period. So the trends of the public sector banks can
be taken as representative of the entire banking system.
It also needs to be noted that the data up to 1987 is available for calendar years
i.e. January to December. The data for 1988-1989 covers 15 months i.e. Jan-Dec 1988
and Jan-March, 1989. So wherever a flow variable is involved it has been deflated by a
factor 12/15 = 0.8 so that it reflects the magnitude appropriate to 12 months duration on
an average basis. 1989-90 onwards, data is available on the basis of conventional
financial years as followed in India i.e. 1st April to 31st March. Data on NPAs has been
obtained from different issues of the ‘Report On Trend And Progress Of Banking In India
(RTPBI)’ published annually by the RBI and for CRAR from ‘RTPBI’ and ‘Handbook
Of Statistics On Indian Economy, 2008’. Data for all other parameters has been obtained
from ‘Statistical Tables Relating to banks in India – 1979-2007’.

While analyzing the pre and post liberalization data, certain factors need to be
kept in mind. First of all reform is an ongoing process, so one should not expect a sudden
jump on a particular date but a gradual change, possibly with a lag, and spread over a
certain time period. So if one finds an improvement even in mid or late 90s it can be
attributed to the reforms undertaken in early 1990s. Secondly, subsequent to the reforms
all banks have adopted new accounting standards7 prescribed by RBI. Therefore the
comparison of pre and post reforms data cannot be made without qualifications. With the
adoption of new norms, the banks’ balance sheet and profit and loss position was bound
to deteriorate. So, any deterioration in observed values can substantially be due to the
changes in the norms rather than other factors. For such an analyses the appropriate
technique would be one that clearly expresses each data value rather than some average
changes over a given time period. The best way of analyses in this case is to look at year-
to-year data assisted by a visual representation of data by means of appropriate graph(s).
Profitability
Profits represent the difference between income and expenditure. The difference
between total income and expenditure of any concern gives its net profit. Net profit plus
provisions and contingencies give operating profit. Table 5.1 gives data on operating
profits (as ratio to total assets) for different categories of banks.
Operating Profits Of Scheduled Commercial Banks

As percent of total assets
All All
State Bank
Private Regional Scheduled Scheduled
Of India Nationalized Foreign
Year Sector Rural Commercial Commercial
And Its Banks Banks
SCBs Banks Banks (Excl. Banks (Incl.
Associates
RRBs) RRBs)
1980 0.08 0.09 NA NA NA NA NA
7
With effect from 1992-1993

1981 0.08 0.08 NA NA NA NA NA
1982 0.08 0.08 NA NA NA NA NA
1983 0.08 0.07 NA NA NA NA NA
1984 0.07 0.06 NA NA NA NA NA
1985 0.08 0.06 NA NA NA NA NA
1986 0.09 0.12 NA NA NA NA NA
1987 0.09 0.13 NA NA NA NA NA
1988-89 0.12 0.13 NA NA NA NA NA
1989-90 0.13 0.17 0.25 1.37 0.22 0.22 0.22
1990-91 0.14 0.18 0.35 1.18 0.29 0.23 0.24
1991-92 2.81 1.27 2.25 5.47 -2.36 2.12 2.01
1992-93 1.89 0.40 1.50 2.04 -2.60 1.07 0.98
1993-94 1.53 0.74 2.08 3.88 -2.54 1.31 1.21
1994-95 1.75 1.13 2.43 4.24 -2.07 1.64 1.54
1995-96 2.29 1.21 2.52 3.68 -1.65 1.83 1.73
1996-97 2.28 1.32 2.53 3.86 -0.60 1.92 1.84
1997-98 2.17 1.44 2.57 4.20 0.53 1.99 1.94
1998-99 1.79 1.31 1.60 2.73 0.98 1.60 1.58
1999-00 1.88 1.39 2.23 3.45 1.34 1.79 1.78
2000-01 1.55 1.36 1.90 3.36 1.59 1.64 1.64
2001-02 2.05 1.94 2.15 3.28 1.45 2.11 2.08
2002-03 2.38 2.47 2.54 3.26 1.20 2.51 2.46
2003-04 2.75 2.93 2.48 3.95 1.57 2.87 2.82
2004-05 2.60 2.27 1.93 3.16 1.02 2.36 2.31

2005-06 2.28 1.86 1.95 3.77 0.91 2.12 2.08
2006-07 1.91 1.89 2.13 4.02 1.22 2.11 2.08
The time period considered is 1980 to 2006-2007. For the years 1980 to 1988-
1989, data is available only for public sector banks i.e. SBI and its associates and
nationalized banks. Since operating profit is considered the magnitudes will not get
affected by changes in the provisioning norms. However adoption of new income
recognition norms will show deterioration in the profitability as measured by operating
profits. Due to changes in classification related to non-performing assets (NPAs), the
total assets of banks will also be affected.
Operating Profits
6.00
5.00
4.00
ratio to total assets
3.00
2.00
1.00
0.00
-1.00
-2.00
-3.00
-4.00
STATE BANK OF INDIA and its ASSOCIATES

NATIONALISED BANKS
PRIVATE SECTOR SCBS
FOREIGN BANKS
REGIONAL RURAL BANKS
ALL SCHEDULED COMMERCIAL BANKS (EXCL. RRBS)
ALL SCHEDULED COMMERCIAL BANKS (INCL. RRBS)

From the chart 5.1 above is evident that after the financial sector reforms; the
profit position of all categories of banks has substantially improved. All the curves in the
chart show a sharp jump in the immediate post-reform period. They however slide
downwards in the year 1992-93 and once again in 1998-99. As explained earlier this is
largely attributable to the adoption of prudential income recognition norms. Despite this
however all bank groups (except RRBs) are able to show positive operating profits.
INDIAN FINANCIAL MARKETS
In the preceding chapters, the focus of attention had been the financial
institutions. This chapter is devoted to a detailed study of the financial markets. Starting
with the importance of financial markets in an economy, it then brings out the
organization and the structure of these markets in India and in what way they have been
affected by the reforms undertaken in the financial sector.
IMPORTANCE
From a financial stability perspective it is necessary to have a financial system

whereby both financial institutions and financial markets play an important role. Stock
market is an important and growing ingredient of the financial market, more so in
developing countries. Well-developed stock markets may be able to offer different kinds
of financial services from financial institutions and a different kind of impetus to
investment and growth8. Increasing stock market capitalization (SMC) may improve an
economy’s ability to mobilize capital and diversify risk. On one hand, there are models
that emphasize the tensions between bank based and market based systems 9, on the other
8
Levine, R. and Zervos, S. (1998) Stock Markets Development And Long Run Growth, World Bank
Economic Review, 10, pp 323-339.
9
Levine, R., (2002), Bank-Based Or Market-Based Financial Systems: Which Is Better? Journal Of
Financial Intermediation, 11(4), 398-428

there exist a number of studies on financial development and economic growth focusing
on complementarity hypothesis10.
One such study suggests that stock markets and financial intermediaries have
grown hand in hand in the emerging market economies. Some other studies also find that
the levels of banking development and stock market liquidity exert a positive influence
on economic growth. Levine and Zervos (1998) show that initial level of stock market
liquidity and banking development are positively and significantly co-related with future
rates of economic growth, capital accumulation, and productivity growth.
The capital market fosters economic growth in various ways such as by

augmenting the quantum of savings and capital formation and through efficient allocation
of capital that in turn raises the productivity of investment. It also enhances the efficiency
of a financial system as diverse competitors vie with each other for financial resources. It
adds to the financial deepening of the economy by enlarging the financial sector and
promoting the use of innovative, sophisticated, and cost effective financial instruments,
which ultimately reduce the cost of capital. Well-functioning capital markets also impose
discipline on firms to perform11.
Equity and debt markets can also diffuse stress on the banking sector by
diversifying credit risk across the economy. While capital markets provide both equity
and debt finance, banks and other FIs as intermediaries specialize in providing debt
finance only. Industry level studies have also found a positive relationship between
financial development and growth (Rajan and Zingales, 1998), but an increase in
financial development disproportionately boosts the growth of those companies that are
10
Demirguc-Kunt,A. And Levine,R.(2001), Financial Structures And Economic Growth: A Cross-Country
Comparison Of Markets, Banks, And Development, Cambridge, MA: MIT Press
11
Beck, T. and Levine, R. (2002) Stock Markets, Banks, and Growth: Panel Evidence NBER Working
Paper Series No.9082 Cambridge, Mass: NBER.

naturally heavy users of external finance. Using firm level data, Demirguc-Kunt and
Maksimovic (1998) show that the proportion of firms that grow at rates exceeding the
rate at which each firm can grow with only retained earnings and short term borrowing is
positively associated with stock market liquidity (and banking system size). Thus, there is
ample literature supporting the role of stock market in economic growth by easing
external financing constraints.
While considering the role of financial markets, specifically the stock market, in
economic development, the associated problems and limitations cannot be ignored. Quite
often, the benefits of stock market are more from the point of view of maximizing
(speculative) returns for the individual investors and market operator. The efficient
market hypothesis mostly does not hold. Actually the stock market valuations are often
incorrect because they are less related to fundamentals and more to speculative
activity/trading. The corporate financing system based on equity finance displays a
tendency to discourage long-term riskier investment in productive physical capital as
companies become pre-occupied with short-term financial return considerations to please
shareholders, and to avoid possible takeovers. The stock market induced liquidity may
encourage investor myopia and weaken investor commitment. It may reduce investor
incentive to exert corporate control and monitor company’s performance, which can hurt
economic growth. In today’s liberalized and globalized economics, stock markets can
easily act as conduit for spreading speculative pressures all over the world12.
Singh (1997) argues that stock market expansion is not a necessary natural
progression of a country’s financial development and stock market development may not
help in achieving quicker industrialization and faster long-term economic growth in most
developing countries for several reasons. First because of inherent volatility and
arbitrariness of the stock market, the resulting pricing process is a poor guide to efficient
12
For a detailed discussion of these weaknesses, see Bhole, L. M., The Indian Capital Market At
Crossroads, Vikalpa, April-June 1995 and Bhole, L. M., The State Of Indian Stock Market Under
Liberalization, Finace India, March 2002.

investment allocation. Second, in the wake of unfavorable economic shocks, the

interactions between stock and currency markets may exacerbate macro economic
instability and reduce long-term economic growth. Third, stock market development is
likely to undermine the role of existing banking systems in developing countries.
SUMMARY AND CONCLUSIONS
AN OVERVIEW
This study has analyzed the impact of the reforms undertaken in the financial
sector on economic growth in India. Starting with an introduction of the financial system
and its development it then gives a brief overview of the Indian Financial system since
independence. This is followed by an outline of the major reforms recommended in the
financial sector as part of Narasimham Committee Report 1 and 2. Next, a
comprehensive survey of literature has been presented. These give theoretical and
empirical overview of the relationship between financial development and economic
growth for developed as well as developing economies. A host of cross-section and time
series studies have examined the finance growth nexus. Different methodologies varying
from ordinary least squares to vector error correction models have been used in cross
country as well as country specific regressions. There exist only a few studies for India
that examine the finance growth relationship. Some studies have examined the
productivity growth and performance of the banking sector in India and also growth of
credit in the economy. However, there is no study on the subject covering the period
after late 1990s
The survey of theoretical and empirical literature is followed by the results of

empirical analyses. Available data shows that substantial financial development has taken
place during the post liberalization period based on various quantitative indicators. The
performance of the commercial banking sector has shown noticeable improvement during
the post liberalization years. The Indian capital market has also undergone major changes

and improvements. Finally it has been found that the financial sector has strong positive
effects on the real sector variables in India.
THE DEVELOPMENT OF THE FINANCIAL SYSTEM
The impact of financial sector reforms on the Indian financial system has been
examined in terms of the changes in the growth rates of savings, investment, deposits,
and credit; various changes in the structure of the financial system, performance of the
commercial banking sector, and size, liquidity and volatility of the stock market. Time
period and methodology differs in each case depending on the availability of data and
nature of analyses.
To start with time series of all stated indicators have been plotted against time.
This gives a fairly good indication of the presence (or absence) and direction of the
trends. Wherever substantial and consistent data is available for both pre and the post
reform periods, in respect to those indicators regression analyses has been used to find
whether there exists a significant difference in the growth rates in the pre and the post
liberalization periods. In cases where substantial pre-reform data is not available or the
magnitudes in entirety have been sharply fluctuating, simple data analysis as explained
above has been done.
It has been found that a substantial increase in rate of growth of both savings and
investment has occurred after the reforms. Of all the cases analyzed the maximum change
has been noted in case of investment by the private sector. Both deposits and credit in
relation to GDP has grown at rates substantially higher than in the pre-liberalization
period. On comparing the equations for credit and deposits it was noted that prior to the
reforms the growth rate of credit was around half the growth rate of deposits. Subsequent
to the reforms it increased to around two-thirds of the average annual rate of growth for
deposits. This also brings out the increase in the proportion of deposits that have been

channeled to the private sector via the financial system. This has been made possible only
by the substantial reductions in the cash reserve ratio, the statutory liquidity ratio, and the
priority sector lending. The banks and financial institutions now have much greater
freedom to deploy the available funds. A number of changes in the structure of the
financial system have also been noted.
The performance of the banking sector has been examined on the basis of
profitability, levels of non-performing assets, capital adequacy ratio, and different
indicators for productivity and efficiency. The available data shows substantial
improvements in profitability of all bank groups after the reforms. With regard to non-
performing assets too, a significant improvement has been made after the reforms. In
mid 90s all bank groups on an average were operating with high level of NPAs. The
position at the beginning of 1990 can be expected to be much worse. By 2006-2007 all
the bank groups had reached a position where they stand very comfortable even in
comparison to the international benchmark of 2%. For productivity and efficiency three
indicators were examined. The intermediation cost ratio had an overall falling trend. The
picture on operating profits per employee and business per employee is that of an up
trend in the post liberalization years (expect foreign banks where relative values were
substantially high in early 1990s).
After liberalization, the banks (in all groups) have substantially improved their
position in terms of efficiency, productivity and profitability. The maximum gain in
performance has been in case of RRBs in terms of all indicators examined. With
deregulation of rates of interest, there now exist active price competition among different
financial players. With removal of restrictions on entry and exit, a number of new private
and foreign banks have come on the scene.
The analyses of the banking sector shows that the commercial banks in India have
experienced strong balance sheet growth and have substantially improved their profit

position in the post reform period. The profitability is at distinctly higher levels for all
post-reform years in comparison to years prior to liberalization. Improvement in the
financial health of banks, as reflected in significant improvement in capital adequacy and
improved asset quality, is distinctly visible. All indicators of productivity that have been
examined stand at a much higher level today in comparison to the years prior to the
reforms. It is noteworthy that this progress has been achieved along with adoption of
international best practices in prudential norms. Technology deepening and flexible
human resource management has largely enabled competitiveness and productivity gains.
Ever since the reform process began in early 1990s, the Indian Capital Market has
witnessed significant qualitative and quantitative changes. Substantial improvement in
terms of various parameters as size of the market, liquidity, transparency, and efficiency
has taken place. The changes in regulatory and governance framework have brought
about an improvement in investor confidence. Together with these developments on the
positive front it also needs to be noted that with opening up to the foreign sector the stock
market has become much more volatile and vulnerable to foreign disturbances.
FINANCIAL SYSTEM AND ECONOMIC GROWTH LINKAGES
In order to ascertain whether or not a causal relationship exists between financial

development and economic growth; as a first step all the variables were examined for
stationarity. Since the tests for stationarity have low power, multiple tests were used i.e.
Augmented Dickey–Fuller (ADF), Phillips-Perron (PP) and KPSS. These tests show the
presence of unit root in all four cases. After taking first difference, all series became
stationary. This means all variables are integrated of order one i.e. I(1). This suggests the
possibility of co-integration among variables. The Johansen tests (max and trace) indicate
the presence of a single co-integrating vector. This means all variables are mutually co-
integrated. Due to trending nature of the series, the co-integration test was carried
including an intercept and with co-integrating restrictions imposed. Since the variables
are co-integrated, the vector error correction model was applied to the variables to obtain

the results on relationship. The order p of VAR (p) was chosen with the help of Hannan-
Quinn (HQ) and Schwarz information criteria (SIC). As per HQ and SIC optimal p i.e.
p*= 1. This was closely followed by p = 4 with only a marginal increase in both HQ and
SIC. Theoretically, it seems that where the impact of finance and capital is involved lag
of 1 year is too small a time span to obtain meaningful results. Moreover with p =1 the
model did not yield theoretically expected signs of co-efficients. So p = 4 was chosen.
Various tests for joint significance were then carried out to examine the impact of
financial development variables on EG and CF and impact of EG on the two financial
variables. These tests indicate that in the long run institutional credit significantly (at 1%
significance level) affects both capital formation and economic growth positively. This
result implies that financial sector reforms have been instrumental in accelerating
economic growth in India. Stock markets do (weakly) influence economic growth (at
15% and above levels of significance) but the impact is small and negative. The impact
of IMCR on capital formation is significantly negative (even at 1%).
LIMTATIONS AND OUTLINE FOR FURTHER RESEARCH
Any statistical study is often constrained by the non-availability of the data

relevant to the analyses. The present study also faced such constrains. Its major
limitations lie in the non-availability of some of the relevant data.
Ideally institutional finance in an economy should consist of funds obtained from

the banking sector, the non-bank financial institutions, and finance companies. In
addition to these the unregulated credit markets also need to be incorporated. In case of
India, consistent data on credit from NBFCs in totality is not available. Even in case of
financial institutions only partial data is available. In context of private unregulated credit
markets too, reliable and complete information is not available about their operations as
there is no official or unofficial agency to which such financers report their operations.

This represents a big gap in the knowledge of finance industry and also hampers
formulation and effectiveness of credit policy.
In context of the Indian capital markets too, the non- availability of substantial pre
reform data on various indicators has been a constraining factor. Moreover no data is
available on any variable that can act as a proxy for human resource development as one
of the explanatory variable in economic growth.
Another limitation relates to the inferences that can be drawn from different
econometric methodologies. The VAR model used in the analyses, although capable of
incorporating the endogeniety of the variables and the lags, does not indicate the exact
magnitudes of various relationships. Simple OLS or GLS techniques that may give such
magnitudes will not be able to give otherwise satisfactory results due to enogeniety of the
explanatory variables. One of the two things has to be sacrificed. Moreover most of the
test results are valid asymptotically. Their reliability in small samples is open to question.
The limitations pointed above are not peculiar to this study but are true for any
statistical study. The only way to take care of these limitations is to interpret the results
with due care keeping in mind these limitations.


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IRJMST Volume 5 Issue 3 [Year 2014] Online ISSN 2250 - 1959

IMPACT OF FINANCIAL SECTOR REFORMS ON ECONOMIC GROWTH IN

AUTHORED BY:SHWETA GARG

Co-AUTHORED BY: SHIVANI GARG

THE FINANCIAL SYSTEM

The term ‘Finance’ in our simple understanding is perceived as equivalent to

International Research Journal of Management Science & Technology

A financial system helps to promote savings and appropriately allocate the

The financial system of any country typically comprises of financial institutions,

I Financial Institutions are like business organizations involved in the sale-

International Research Journal of Management Science & Technology

Intermediaries themselves can be further classified as bank (RBI, commercial

1. They participate in economy’s payment mechanism i.e. provide transaction

II Financial Markets are a significant component of any financial system. These

International Research Journal of Management Science & Technology

A. Based on maturity structure, we can talk of money market and capital-market.

International Research Journal of Management Science & Technology

ROLE OF FINANCE IN ECONOMIC GROWTH

The relationship between finance and economic development is a long debated

International Research Journal of Management Science & Technology

leading’ financial development i.e. financial development precedes economic

 Increasing savings rate and therefore investment.

EVOLUTION OF THE INDIAN FINANCIAL SYSTEM

Pre-Independence: The Indian financial system, on the eve of planning, was

International Research Journal of Management Science & Technology

Post Independence: With the initiation of planned economic development in

A BRIEF OUTLINE OF THE PROPOSED STUDY

International Research Journal of Management Science & Technology

Thus, the study is organized in two parts:

 Impact of financial sector reforms on the development of Indian Financial

 To study the reforms taken place in the financial sector.

1. In the post-liberalization period (as compared to the pre-liberalization period).

International Research Journal of Management Science & Technology

e. Performance in terms of profits and productivity of the financial sector has

FINANCIAL SECTOR REFORMS

When India became independent in 1947, it was a backward, primarily agrarian,

International Research Journal of Management Science & Technology

NEED FOR REFORMS

International Research Journal of Management Science & Technology

THE REFORMS OF 1991 (NCR-I)

International Research Journal of Management Science & Technology

Following were the major re-commendations:

SLR to be brought down is a phased manner to 25% over a period of 5 years. It

THE SECOND GENERATION REFORMS 1998 (NCR-II)

The major recommendations included increase in CRAR to 10% by 2002, new

International Research Journal of Management Science & Technology

DIFFERENT VIEWS IN LITERATURE

Goldsmith’s (1969) pioneering study to assess whether finance exerts a causal

International Research Journal of Management Science & Technology

by a number of factors – physical, technical, economic, and mass psychological in nature.

He used the financial inter-relationship ratio (FIR) as the single main

International Research Journal of Management Science & Technology

THE STUDIES FOR INDIAN ECONOMY

In case of Indian Economy, data on extensive set of measures of economic

Bhattacharya, et al (1997) studied the impact of increased competition due to

International Research Journal of Management Science & Technology

Financial Development In India: Pre And Post Liberalization

FINANCIAL DEVELOPMENT: QUALITATIVE ASPECTS AND QUANTITATIVE

A financial system operates through financial institutions and markets. These

Financial development thus is a broad concept incorporating a number of

International Research Journal of Management Science & Technology

Financial development usually involves upcoming of a number of private sector

INDICATORS OF FINANCIAL DEVELOPMENT