How India’s financial markets have evolved and developed over the years?

K.P. Krishnan  (at Capital Markets Division of the Department of Economic Affairs, Ministry of Finance)  writes a paper tracking developments in various segments of India’s financial markets

The paper is good as it covers a lot of ground covering many segments of financial markets. However, its policy suggestions are questionable given the global crisis.

It begins looking at research measuring financial development in general and in India. The summary is:

It would a fair summary to say that as per these reports, based on reasonably standard and agreed criteria, India does not rank very high in its overall score of financial development. However, it is relatively well placed in terms of development of nonbanking financial services (seventeenth) and financial markets (twenty-second). Within the financial markets, India fairs well in development of its foreign exchange markets and derivatives markets. Some of the subindicators in which India ranks well are regulation of securities exchanges (ninth) and currency stability (tenth). However, the country’s institutional environment is considerably weaker, ranking forty-eighth, a consequence of its lower levels of financial sector liberalization as well as a low degree of contract enforcement. India’s business environment is also affected by two particular challenges: an absence of adequate infrastructure and the high cost of doing business. These areas of difficulty translate into highly constrained financial access.

As this blog keeps saying….. financial inclusion and development are just one and limited aspect. Real sector development and inclusion is a much bigger issue.

It then covers the developments in various segments of the financial markets:

  • Equity
  • Derivatives
  • Debt markets
    • Government Bonds
    • Corporate Bonds
    • Money Markets
  • Banking
  • Insurance
  • Foreign Exchange

There are some superb tables with figures to take you through.  What is the summary of this analysis?

Looking both at the story of growth and development of each of the segments of financial markets in India described in above and the more numbers-based evidence in the first section, one cannot escape the fact that they point to two contradictory developments; the dramatic transformation of the stock market segment but the considerably more limited progress in other segments of the markets. In other words, one could broadly say that while India has done well in terms of creating efficient equity and equity derivatives, development in the banking sector services, bond markets, retail access to finance, and general business environment leaves much to be desired.

Author says this pace of reforms is because of government’s role. Wherever government is dominant, pace of reforms is the slowest! This is quite a statement from an official in Finance Ministry:

The extent and pace of reforms in a segment of financial markets in India appear to be shaped by two factors: a clearly defined regulatory framework and the extent of public sector presence. The debt markets in India illustrate this. The debt market has had a strong public sector presence. The dominant traded instruments are Government of India securities, and the dominant trading participants are banks, with a large fraction being the public sector banks. When the Securities and Exchange Board of India (SEBI) was created to regulate “securities markets,” the markets for bonds did not fall within its mandate due to confusion in the financial architecture prevalent in the country.

 ….the government dominated the insurance and banking sector, where the pace of the reforms has been the slowest. The government had a lower involvement in commodity markets, and the least in the case of equity, where reforms have made huge strides in institutional development and change.

Other factor is banning people from certain markets:

Some of the other reasons for the varying pace of development in different sectors of the financial markets are bans or restrictions on products and participants. A policy environment that bans products and markets clearly hinders the development of liquid and efficient markets. As an example, exchange-traded currency futures were banned until August 2008, and commodity options are currently banned, obviously impeding the development of liquidity and efficiency in these markets. Equally problematic, a missing market can hamper the efficiency of other markets as well. For example, an efficient and deep corporate bond market is still lacking in India, inter alia, because the related markets for corporate repos, interest rate derivatives, and credit derivatives are either altogether missing or have only been allowed with multiple restrictions, which lead to stunted development.

For regulation he says:

Regulatory structures need to be streamlined to avoid regulatory inconsistencies, gaps, overlap, and arbitrage

Options that can be explored to achieve greater regulatory convergence, based on recommendations of various government committees fall into two main categories.

The first category concerns different degrees of convergence. One option is convergence of the commodity derivatives and securities market, that is, one regulator for the equity, corporate debt, equity derivatives, and commodity derivatives markets. Another option is convergence of organized financial trading, that is, one regulator for the aforementioned commodity derivatives and securities market plus interest rate derivatives, foreign exchange derivatives, government securities, and all derivatives thereon. The third option would be convergence of all financial sector regulators, that is, one regulator for all of the above plus insurance and pensions, with the central bank retaining regulatory control over the banking sector.

The second category concerns policy level convergence. This would mean that all financial sector regulation and regulators would be covered under a single legislative enactment and under a single department, even with multiple regulators. Each of these alternatives needs to be explored.

Along with streamlining the regulatory framework, there is also a need to review the actual financial regulations, which tend to be “rule based” and overly prescriptive, inserting every minute detail into the basic legislation and including detailed subordinated rules and regulations. The suggestion here is to move toward more principles-based regulation to promote financial innovation and avoid the mistake of overregulation. However, even if the regulatory system continues to be rules based, then given the pace of financial innovation that a country that is growing as fast as India requires, there should definitely be a constant revisiting of the rules that are in place. Otherwise, system risks getting stuck in an old set of rules that will restrict the pace of growth in the country. Regulatory impact assessment could serve as an important tool for evaluating the costs and benefits of various aspects of the regulatory architecture and implementation to guard against the error of overregulation.

Based on this, he says lessons from the crisis are not to restrict finance but let it move ahead and innovate:

Among the right lessons that can be drawn from the crisis are:

i. Innovation in financial markets should not be strangled. However, it should be ensured that the complexities of new products are understood, especially if they are traded off exchanges, as OTC products. When widely distributed and poorly understood, such products are dangerous to systemic stability.

ii. Too much risk aversion on part of regulators can impede growth and development.


iii. There is no perfect regulatory architecture, but institutional design needs to be in tune with markets and requirements.

Inclusion, growth, and stability are the three objectives of any reform process, and these objectives are contradictory. With the right reforms, the financial sector can be an enormous source of job creation both directly as well as indirectly, through the enterprise and consumption it can support with financing. Without reforms, however, the financial sector could become an increasing source of risk, as the mismatches between the capacity and needs of the real economy and the capabilities of the financial sector widen. India has been a case study of how financial sector reforms can play a supporting role in the growth of an emerging market economy. The challenge is how to bootstrap from these past successes to escalate to the next level of financial sector development, so that it can continue to support the growth that India faces going forward.

The real problem is not many know what financial sector development now means.  All these concepts like principles based regulation were seen as innovative before the crisis. Not anymore. It is all tilting towards rules based regulation.

Authors keep saying not to strangulate finance. Well, that is not as issue at all as to do that regulators need to first understand what is going on in financial sector. It is clearly a case of trying to regulate not stranguate finance. The crisis financial sector has brought itself in implies thorough examination of practices in financial industry. One cannot divorce principles of financial economics from the practices in financial sector. There is a major disconnect between the two as of now.

Another aspect is need to usher reforms in real sector. Somewhere down the line it needs to take precedence. Financial sector reforms alone cannot help when the real sector is not innovative or constrained due to laws. Without opportunities in real sector, financial sector development mostly leads to speculation and then a crisis. For instance, people keep saying we need to develop corporate bond market to enable infrastructure financing. But the whole infrastructure sector is a mess with just no clarity on rules and regulations.

Finance follows real sector not other way round. The current events (and plenty of others) shows the reverse flow (finance leads real sector) just leads to crisis.

Though this does not mean India does not need reforms in financial sector. Just that we need to be more active in the real sector reforms…

2 Responses to “How India’s financial markets have evolved and developed over the years?”

  1. laxshmipasi Says:

    it is a good source of knowledge for those students like us who are interested to be aware about the financial condition of the Indian economy . nice …

  2. handloom Says:

    Leadership mastery in the digital age requires an integration of skills. Whether your dominant skill is technology aptitude or your dominant skill is dealing with people the future requires all of us to integrate our skills to achieve mastery of leadership in the digital age.

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