Financial Services in India

Submitted by Rimjhim Singh PGDFS Sem. II ? Financial Services in India The financial services sector contributed 15 per cent to India’s GDP in FY09, and is the second-largest component after trade, hotels, transport and communication all combined together, as per the Banking & Finance Journal, released by an industry body in August 2010. Share of Financial services, banking, insurance and real estate sectors is expected to enhance by 9. 7 per cent for the year 2009-10 to 17. 2 per cent of GDP (at factor cost).

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Data sourced from SEBI shows that the number of registered FIIs stood at 1,738 and number of registered sub-accounts rose to 5,592 as of November 10, 2010. Overseas funds infused into Indian capital market in 2010 stood at US$ 39 billion. According to data released by Securities and Exchange Board of India (SEBI), stocks and debt securities over worth US$ 17. 28 billion were purchased by the foreign institutional investors (FIIs) from the Indian capital market in January 2011. According to data available with SEBI, FIIs have made investments worth US$ 4. 11 billion in equities and invested US$ 667. 1 million into the debt market. The average assets under management of the mutual fund industry stood at US$ 147. 99 billion for the quarter ended December 2010, according to the data released by Association of Mutual Funds in India (AMFI). As on January 21, 2011, India’s foreign exchange reserves totaled US$ 299. 39 billion, according to the Reserve Bank of India’s (RBI) Weekly Statistical Supplement. According to Venture Intelligence, a research firm, private equity firms invested US$ 7,974 million over 325 deals in India during 2010, as against US$ 4,068 million (over 290 deals) in 2009.

The largest investment reported during the year was the US$ 425 million raised by power generation firm Asian Genco from investors including General Atlantic, Goldman Sachs, Morgan Stanley, Everstone and Norwest. According to a global consultancy firm Ernst & Young (E), sectors such as power and transportation, consumer and branded products, infrastructure ancillaries, education and financial services, and healthcare are likely to witness increased PE activity in 2011. Deals

India Inc announced merger and acquisition (M) deals worth a record US$ 55 billion in 2010, including a record number of billion-dollar transactions. The number of mergers and acquisitions (M), private equity (PE) transactions and Qualified Institutional Placements (QIP) increased close to 40 per cent to US$ 3. 23 billion in November 2010. Besides, there have been US$ 9 billion plus deals in 2010, the highest seen in any year. Fund-raising activity gained pace by almost 65 per cent in 2010 as compared to 2009. In real terms, 27 funds were able to raise US$ 13 billion as PE as against US$ 8 billion by 22 funds in 2009.

There has also been a more than 80 per cent growth in PE and VC investments in India: 2010 witnessed 348 deals worth $8 billion, against 317 deals worth $4. 4 billion in 2009, according to VCCedge data. Stock markets Market capitalisation of India as a proportion of world market cap has risen to a record high. According to data sourced from Bloomberg, the country’s market capitalisation as a proportion of the world market cap is currently 3. 34 per cent. India’s current market-cap is US$ 1. 55 trillion as compared with world market-cap of US$ 46. 5 trillion. This is higher than 3. 2 per cent share India enjoyed at the market peak of January 2008. As analyzed by Venture Intelligence, private equity firms obtained exit routes for their investments in a record 121 companies during 2010, including 24 via IPOs. (2009 had witnessed 66 liquidity events including 7 via IPOs). PE-backed companies raised about US$ 2. 20 billion via IPOs during 2010. Insurance The Indian Life Insurance industry is one on the strongest growing sectors in the country. Currently a US$ 41-billion industry, India is the fifth largest life insurance market and growing at a rapid pace of 32-34 per cent annually.

Currently, there are 22 life insurance companies operating in India, according to the Life Insurance Council (LIC). According to data released by the Insurance Regulatory and Development Authority (IRDA), insurance companies garnered US$ 11. 73 billion in new business premium during April-August 2010, against US$ 6. 90 billion in the corresponding period last year. Further, according to IRDA, in October 2010, life insurance companies collected first year premium worth US$ 542. 19 million (individual single premium). For the period up to October 2010, total premium collected by life insurance companies was US$ 4. 6 billion, as compared to US$ 2. 39 billion collected in the same period of 2009 (individual single premium). The life insurance industry is expected to cross the US$ 66. 8 billion total premium income mark in 2010-11. “This year, we are expecting a growth of 18 per cent in total premium income. If achieved, it is expected to cross the US$ 64. 4 billion mark,” said SB Mathur, Secretary General, Life Insurance Council. Total premium income, at US$ 56. 04 billion, rose 18 per cent during 2009-10, against US$ 47. 6 billion in the previous year. Banking services Significantly, on a year-on-year basis, bank credit grew by 24. per cent in 2010 as against RBI’s projections of 20 per cent for the entire fiscal 2010-11. The financial service sector has been gaining increasing importance in today’s rapidly globalising economy. This importance has been recognized in theoretical literature in terms of its contribution towards long-term growth and efficiency given its intermediate role in channelling resources to all sectors of the economy. This sector has seen massive internationalization due to widespread liberalization around the world which includes domestic financial deregulation, capital account liberalization and opening up to foreign competition.

This globalization of financial services has however led countries to be more concerned about the potential risks of opening of this sector and is forcing them to be more cautious by strengthening their prudential regulatory and supervisory standards and capability in line with international best practices and standards. The financial services sector accounts for a significant share of economic activity in most countries. The sector is recognized for its contribution towards long-term growth and efficiency given its intermediate role in channelling resources to all sectors of the economy.

Improved provision of financial services enables greater efficiency in other sectors by expanding the range and enhancing the quality of such services, by lowering costs of funds, and by encouraging savings and more efficient use of these savings. The financial services sector has undergone important structural changes in recent years with growing numbers of worldwide cross border mergers and acquisitions and increased competition among different types of financial institutions.

These structural trends are evident from rising cross border trade and foreign investment flows in financial services, with the developed countries being the main exporters of such services. As a result, the financial services sector has become an important part of the overall globalization of the service sector. Financial Services in the Indian Economy The structure of India’s financial sector can be assessed in terms of the institutions that comprise this sector as well as the various financial markets in which these institutions interact and carry out transactions.

The most important segment is the banking sector. The latter comprises the Reserve Bank of India, commercial banks, and cooperative banks. Commercial banks include scheduled and non-scheduled banks, which are banks that are required to keep a minimum amount of capital and obey RBI directions concerning the cash reserve requirement (CRR) and are permitted to borrow from the RBI. Most commercial banks in India are in the scheduled category.

Commercial banks fall into three groups, namely Regional Rural Banks, which are government sponsored regionally based rural oriented banks, public sector banks, which are banks that are owned by the government, and private banks, which may be Indian branches of foreign banks or domestically owned private banks. Other financial institutions consist of term-lending institutions- some of the largest ones being IDBI and ICICI, mutual funds- a major one being Unit Trust of India (UTI), and the insurance sector which till recently was under government monopoly but today also consists of private insurance companies.

The structure of the financial sector is presented below There are three sets of financial markets in which the aforementioned institutional entities interact and carry out transactions. These are, namely, the money, credit, and capital markets. The money market consists of call money, certificates of deposit, commercial paper, and commercial bills. The credit market consists of short-term loans by commercial banks and long-term loans by term lending institutions.

The capital market consists of the government securities market and the market for corporate stocks and debentures. The structure of the financial market in India is presented below. Over the last few decades, the role of the financial services sector has grown in the economy, mainly due to the growth of the banking and non-banking segments. According to CSO statistics on the sectoral distribution of GDP, the share of banking services in total value added in services increased from 6. 3 percent in the 1980s to 11. 2 percent in the 1990s and was close to 12 percent in 2001-02.

The share of insurance services in total services value added, however, declined over this period, from 1. 5 percent in the 1980s to 1. 4 percent in the 1990s and stood at 1. 2 percent of GDP in 2001-02. 16 If one adds to this the value added due to the non banking financial services segment, financial advisory and information services, mutual funds, and other activities which are not reflected in the national accounts statistics in a disaggregated manner, then the share of the financial services sector within the service sector is likely to be much greater.

According to Sen and Vaidya (1998), the segment of financial and business services which includes commercial banks, non-banking financial organizations, post office savings banks, cooperative credit societies, life and non-life insurance activities and other economic activities such as ownership of dwellings, real estate services and business services, constitutes over 20 percent of value added. The segment’s share in the service sector increased from 24. 7 percent in the 1980-86 period to 27. percent in the 1991-94 period, although its share declined to around 25 percent for the 1994-98 period. 17 In terms of value added at factor cost, the banking segment grew at an average growth rate of 11. 8 percent during the 1990s and as much as 15. 8 percent in 1999-00, much higher than the average growth rate of around 7-8 percent for the service sector as a whole during this period. The insurance sector growth was lower at 6. 6 percent during the 1990s, and lower than the average growth rate for the service sector as a whole during this period.

The overall growth in India’s financial services sector has been due to various factors. These include in particular the growing monetization and financial intermediation in the economy, due in large part to the financial sector reforms and deregulation of the 1990s. The opening up of the economy has led to increased portfolio and direct investment inflows in the financial services sector. For instance, according to Ministry of Finance sources, this sector has attracted 8 percent of total cumulative foreign investment during the 1992-01 period.

Increased resources have also been mobilized from the capital markets, of which about 52 percent was directed at banks and financial institutions during the 1992-2000 period. The following discussion briefly highlights the state of the Indian financial services sector prior to reforms and then outlines in detail the evolution of individual segments as well as recent trends and regulatory developments within this sector in the post-reform period.

The banking system India’s banking sector has been marked by three distinct phases, i. e. , the pre-nationalization period from 1947-68, the post-nationalization period, from 1969-91, and the reform period, from 1991 onwards. During the 1947-68 pre-nationalization period, the banking sector operated in a fairly liberal environment. However, over this period, the RBI consolidated its role as the main agency in charge of the supervision and control of banks.

It was empowered to stipulate minimum lending rates and ceilings on various types of advances and to influence credit availability and liquidity management by the banking system through changes in the cash reserve requirement and interest rates. It was also entrusted with the task of developing a sound banking system along modern lines, such as through the Banking Companies Act of 1949 which empowered the RBI to control the opening up of new banks and bank branches, inspect banks’ books of accounts, and prevent voluntary winding up of licensed banking companies.

Subsequent amendments to the Banking Companies Act further increased the RBI’s control over the liquidation of banks, mainly in view of rising bank failures during this period. This period also saw the merging and closure of weak banks, resulting in consolidation within the banking system, with the number of scheduled and non-scheduled banks falling from 566 in 1951 to 85 in 1969. 19 A deposit insurance scheme was also introduced in 1962 with the establishment of the Deposit Insurance Corporation.

In addition to the supervisory and regulatory role of the RBI, the latter’s promotional role in the economy also grew during this period, particularly with respect to provision of agricultural credit. There was an expansion of the banking system to rural and semi-urban areas and with the establishment of the State Bank of India, there were distinct efforts to expand rural branches and expand the reach of the banking system, with a view towards improving credit allocation.

The next period was 1969-1991, starting with the nationalization of 14 commercial banks in 1969 till the launching of financial sector reforms and concerted efforts to deregulate the financial sector. During this period, there was significant growth in the commercial banking system in terms of its geographical coverage as well as the amount of resources mobilized. The share of deposits in national income rose from 15 percent in 1969 to 50 percent by 1991. There was a more than seven-fold increase in the number of bank branches during this period, particularly in rural areas. 0 The deepening of the financial sector was mainly a result of strictly enforced branch licensing policies by the RBI and active intervention by the RBI during the 1970s and 1980s to use the financial sector to meet various social and developmental objectives. During this period, India also developed the largest postal savings network in the world, with over 100,000 post offices spread around the country, which served as a place for mobilizing small savings and for marketing life insurance products, though not in a commercial manner.

The post office sold savings certificates and also generated recurring deposits through postal agents. 21 However, extensive social control of the banking system also exacted a price on the financial sector. The banking system witnessed declining productivity and efficiency and an erosion of profits throughout this period. 22 In 1990-91, net profits as a percentage of working funds of scheduled commercial banks were in the range of 0. 16 to 0. 2 percent as compared to higher profitability ratios of 0. 9 for Indian owned private sector banks and 1. 45 for foreign banks. Most of the banks also suffered from problems of overstaffing, low quality workforce, trade unionism, and too many unviable branches. The banking system was slow to adopt new technologies such as ATMs and internet banking as well as changes in work practices, which had an adverse impact on the quality and variety of services offered. Such deficiencies further raised the operational cost of banking services in India and also hurt their profitability ratio (return on assets).

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