An overview of different parts of the financial system through the lens of reform puts in focus the role of individual regulators and political will in moving the needle.
This article is part of the series 30 Years After: Review and Renew the Reforms Agenda.
At the heart of the complex web of bits and bytes that is the modern financial system is the ability to exchange and transfer capital (money) between various participants in an economy. Borrowers, lenders, investors and entrepreneurs form the four corners of this very busy square. Traffic flow and participants can either be controlled and owned by the government as it was in India till 1991, or it can be regulated by a set of independent regulators appointed by the government, as it is today in 2021.
When we see the hectic activity in the Indian financial system today, we tend to forget what it was like just 30 years ago — in terms of scale, products, efficiency, cost and service. The sole job of a financial system is to trundle money around to find its optimal use in terms of returns at a low-cost and safety of transactions. But the centrally planned Indian economy used the state-owned financial institutions such as banks and insurance companies to gather household savings for its own use, hard coding this into the reserve ratios in banks and investment guidelines in insurance firms.
From running banks, insurance companies and mutual funds to deciding interest rates and even IPO prices, the opening up of the financial sector to private firms post 1991 has transformed the marketplace on both the supply and demand sides. The changes on the customer side have been deep and wide and the difference is palpable to anybody over 40 years of age. Others can ask their mums. I will map the various parts of a financial system on various metrics to see the big changes across these 30 years. Some have used the freedom to soar higher and other sectors have gone kicking and screaming towards the market. Some, like the Public Sector Undertakings (PSU) employee unions and insurance unions are still muttering dark threats as the winds of reform continue to blow stronger.
I will look at four parts of the intermediation market that connects savers to borrowers and investors to entrepreneurs to see what the reform report card looks like over this 30-year period.
An economy the size of India needs a banking sector that is much larger and far more robust than it is today. Reforms that began with the Narasimham Committee in 1991 have aimed to do that but have had mixed results. In 2017, India’s bank assets to GDP ratio stood at 68.4 percent compared to China’s at 174.5 percent, Brazil’s at 105.3 percent and Nepal’s at 85.4 percent. Bank credit to GDP numbers, too, are less than half of the emerging market and developed economies levels. A slew of reforms starting 1991 — that allowed in private sector banks, gave them the freedom to set interest rates, a work-around the dysfunctional priority sector lending rules, and relaxed bank branches regulations — gave India new banks, products and service standards, but have stopped short of giving India the banking system it needs.
As a regulator, over the 30-year period, the Reserve Bank of India (RBI) has been successful in preventing depositors from losing money to bank failure in the scheduled commercial banks, but not in preventing conflicted or poor lending by banks. It has been successful in working with the government and the team at iSPIRT to put in place a state-of-the-art payments system as a digital public utility, but has failed in preventing banks from being centres of mis-selling of own and third-party financial products to retail investors. Reform in banking could not move the banking coverage statistics much, until Prime Minister Narendra Modi in 2014 personally pushed the envelope through the Jan Dhan accounts scheme raising the banked population by a huge 425 million.
But the separation of the public debt management role of the RBI that conflicts with its role as a banking regulator has not happened; neither has the creation of a regulator that looks at retail consumer protection issues. The Financial Resolution and Deposit Insurance Bill, that aimed at giving India an early warning system for the financial system, was effectively scuttled by the banking and Left lobbies, leaving the system vulnerable to sudden blow-outs. The RBI has struggled with dual control over the governance of public sector banks and with ‘phone banking’ from Delhi that funnelled credit to the non-investment worthy or just conflicted lending. It would be fair to say that technology and Jan Dhan have done more for banking reform than the incremental snail-paced change that other parts of banking have seen in India.
Life insurance firms were nationalised in 1956 and general insurance firms in 1972 so that they could better serve the needs of a developing nation. But it ended up creating a monopoly that funnelled cheap household savings to finance the government deficits, while giving an army of agents entitlements that have been almost impossible to take away. The livelihood issue of lakhs of agents has come between basic consumer protection and reform in the insurance industry in India. Reform has happened. But slowly. Kicking and screaming. And without much thought to the final outcome, it has mostly tried to balance the profits of the firms with the commissions of the agents, leaving policyholders to bleed year after year.
The birth of a regulator in 1999 in Hyderabad was the start of the gradual opening of a monopoly market to private and foreign firms and capital, with a reluctant 26 percent foreign equity allowed initially. It took the next 30 years to get FDI in insurance to 74 percent. But real reform has been elusive as the regulator has been weighed down by the monopoly mind-set of the staff and leadership. Its location in Hyderabad prevents top financial talent from joining the creaky bureaucracy that is the Insurance Regulatory and Development Authority of India (IRDAI).
The life industry went through a giant upheaval when the supposedly new age transparent market-linked product was introduced, called the unit linked insurance plan (ULIP). It quickly replaced the traditional policies with more than 70 percent of the first-year premium coming from ULIPs by the year 2007-08. The regulator was played by some foreign and Indian top insurance leaders who exposed Indian investors to market-risk riding on the platform of the older more secure product — the guaranteed insurance policy. Investors lost over INR 1.5 trillion over a seven-year period ending 2012 due to mis-sold ULIPs. There was an uproar in North Block and the rules were tightened in 2010. By 2011, the industry had gone back to selling traditional plans, but now with blood on the fangs. Investors continue to lose money to lapsed policies year after year.
With such poor consumer protection rules in place, it’s no wonder that despite 24 life insurance firms and 34 general insurance firms, coverage of the Indian population remains at an abysmal 2.8 percent (it was 2.7 percent in 2001) for life and 0.9 percent (0.6% in 2001) for general insurance. In terms of size, the life industry has grown at an average annual rate of 19 percent with assets under management (AUM) of INR 38.9 trillion as on 31 March 2020. However, with the 61st month persistency rate at 44 percent, life insurance is a leaky ship in India with the savings of households bleeding away year after year.
The policy dream of life insurance providing long-term funds for infrastructure (and hence all the tax breaks and kid-gloves handling) remained on paper since less than half the policies complete a full five years, let alone the 15-20 years of policy investing term they were supposed to do. General insurance reform has been slow and unconcerned with policyholder focus. A big change was the removal of the tariffs in 2007 by IRDAI allowing free pricing of premiums. But neither in terms of reach, nor in terms of effective consumer satisfaction, nor in providing the funds that the long term infra projects need, has the sector seen much success.
Mutual Funds: “A”
From a 5 percent cost per trade to zero brokerage. From a closed brokers club and old-world physical trading using the outcry method, the securities market in India now has state-of-the art technology, institutions, systems and processes. Starting with the setting up of the market regulator Securities and Exchange Board of India (SEBI) in 1992; the setting up of the National Stock Exchange (NSE) as a transparent screen-based, real time institution; to the setting up of the depositories and clearing corporations, the Indian stock markets are today state-of-the-art in terms of costs, efficiency and volume of business. The most important part of this — which began with investor protection for retail investors, and is now becoming the vehicle for bond market reform — has been the way the Indian mutual fund industry has emerged as a key intermediary between investors and firms.
From one state-owned Unit Trust of India with an AUM of INR 6,700 crore in 1988, the mutual fund industry is now managing over INR 33 trillion at the end of FY2021. The right metric will be to map the rise in assets from the time private firms were allowed to set up shop in 1993 and we see that assets grew at an average annual rate of 16 percent during this time. This asset growth has happened in an increasingly tighter regulatory regime over the years. A regulatory view that mutual funds are retail vehicles for investing in the securities market has resulted in a globally competitive product with thin costs and a product structure that is mostly not open to manipulation. Retail investors have understood the product and the systematic investment plans clock in almost INR 9,000 crore a month, as on May 2021.
The mutual fund industry in its current form is the direct result of a proactive SEBI that has, over the years, put in rules that have been aimed at investor protection. From taking away the 6 percent new fund offer charges, to removing the front load on sales, to many under the bonnet changes, SEBI has gone on raising the bar on costs, transparency, efficiency and governance in the industry. With 44 asset management companies in 2021 — running schemes across equity, debt, overseas securities and gold — the fin tech solutions have made the product accessible to the urban mass affluent investor at zero cost. Mutual funds have now emerged not just as a reliable vehicle for retail investors — periodic accidents notwithstanding — but as a destination for funds for other institutions such as banks, insurance firms and pension funds. The lack of a corporate bond market has hampered the growth and efficiency of debt funds, and while this is a problem that the banking regulator should be solving, SEBI is working to create a market using the mutual fund route.
The pension market remains fragmented across various regulators. The largest corpus sits with the Employees’ Provident Fund Organisation (EPFO) that is regulated by the Labour Ministry. Pension plans from the insurance industry have the oversight of IRDAI. Mutual funds used to have pension plans, regulated by SEBI. After many political battles, India got its market-linked pension system with the National Pension System (NPS) that started on 1 January 2004, though the Pension Fund Regulatory and Development Authority (PFRDA) Act was notified only in 2014, a decade later.
The pension market is a case study to see why reform has been both tough and broken in India. Turf wars that prevent the collapse of all pension products under a single regulator, political vested interests that keep the sunlight of transparency to shine on the dark pools of assets, and the bogey of foreign investment, have all held back a serious, big bus, long-term pool of funds to be made available to firms for infrastructure funding.
With over INR 16 trillion of assets under management, the EPFO is the largest pension institution in the country with 47 million contributing members. By contrast, NPS has assets of just over INR 6 trillion due to the mandatory central government employee contributions. Reform in the EPFO has been slow and reluctant. A fund this size that still ‘declares’ a return each year and does not mark-to-market its assets is a cause for concern.
An overview of different parts of the financial system through the lens of reform puts in focus the role of individual regulators and political will in moving the needle. One reason for the difficulty in this space in banking and insurance has been the role of PSU firms and banks and the discretionary power for rent-seeking by the babus and politicians and their families from feeding on the savings of the Indian households.
In addition, India’s post-Independence forced socialist DNA comes in the way of more market rather than less, even though less market means big blow ups that taxpayers pay for and inflation eats into. India needs to cleanse itself of the socialist brainwash over the decades and step into the freedom of personal choice in regulated markets with little scope of rent seeking by the powers that be.