Q1. “Banks have largely failed at improving financial inclusion in India”. Discuss.

Ans: The concept of financial inclusion is not unique in India. The Government of India
and the Reserve Bank of India have been making concerted efforts to promote financial
inclusion as one of the important national objectives of the country. Some of the major
efforts made in the last five decades include - nationalization of banks, building up of
robust branch network of scheduled commercial banks, co-operatives and regional rural
banks, introduction of mandated priority sector lending targets, lead bank scheme,
formation of self-help groups, permitting BCs/BFs to be appointed by banks to provide
door step delivery of banking services, etc. The fundamental objective of all these
initiatives is to reach the large sections of the financially excluded Indian population.

Traditionally, banks have not considered the poor to be a viable market. Most formal
financial institutions are reluctant to serve them and MSMEs because of perceived high
risks, high costs involved in small transactions, low relative profitability, and inability to
provide the physical collateral usually required by such institutions. In technical terms,
problems of adverse selection and information asymmetries make it difficult for financial
institutions to screen and to monitor credit decisions. RBI’s decision to give approval to
various payment banks has been a game changer in terms of improving financial
inclusion in India. With the advent of rapid advancements in technology and exponential
growth in penetration of telecom services and mobile phones, technology will be the
main reason which will lead to financial inclusion.

Banks have had attempts to improve financial inclusion in India but considering the
existence of a large and well-regulated financial system dominated by commercial banks,
it can be said that banks have largely failed in improving financial inclusion in India. The
following are the major reasons why they have failed:

a) Inadequate Infrastructure: Banks haven’t penetrated into the rural areas primarily
due to poor infrastructure. Setting up a branch or even a micro branch for that matter
was tough due to poor basic infrastructure facilities like electricity, skilled labor etc.

b) Lack of Financial Literacy: People in rural areas have low financial literacy and
thus they didn’t really understand the utility of opening a bank account. They thought
transacting through banks is a complicated and cumbersome process where banks
charge high fees and so they were financially excluded from the formal banking
system.

c) Lack of KYC Norms: Lack of KYC norms is another major reason why banks were
unable to contribute in the financial inclusion agenda as they didn’t have sufficient
information required to process the legal formalities. Aadhar was a big boost and
solved this KYC problem for both banks and the people in rural areas.

d) Lack of Government Initiatives: Although there were schemes earlier which

promoted financial inclusion but their implementation was poor which led to
resentment amongst banks to actively participate in improving financial inclusion in
India. With the advent of PMJDY (Pradhan Mantri Jan Dhan Yojna), the intent of the
 government was clear and the implementation was smooth which helped banks and
other financial institutions to be more confident and optimistic about improving
financial inclusion in India.

Q2. “The Rajan Committee recommendations for greater liquidity in markets are
also prone to major risks”. Comment.
Ans: The Rajan Committee had recommended to allow greater participation of foreign
investors particularly Foreign Institutional Investors (FII’s). Proposal 2 and Proposal 19
recommended to deregulate the current regulations and restrictions on Foreign
Investments to enable FII’s to invest in a prudent manner. Increased liquidity in the
market has its own advantages which are that the markets become more efficient and
robust. Higher liquidity in markets ensure securities can be sold rapidly, with minimal
loss of value, any time within market hours. Also, there are always ready and willing
buyers and sellers of a security which protects the investors from getting stuck on to their
positions. On the other hand, greater liquidity in the markets caused due to increased
participation of both Foreign Institutional Investors (FII’s) and Domestic Institutional
Investors (DII’s) are also prone to major risks. Some of the risks that the markets might
be exposed to are:

a) Higher Volatility: Large volumes of buying and selling activities by foreign

investors can cause higher volatility in the capital markets by uncertain price
movements which can increase the level of risk in the equity and bond markets.

b) Price Rigging: Sometimes FII’s buy extensively when the price is too low and move
the price higher making considerable profits and then selling the same security when
the price is too high to bring it very low thus making profits again. Hence FII’s gain a
lot at the cost of domestic investors due to their manipulation which is possible owing
to integration of Indian equity market with global markets due to liberalization.

c) Devaluation of Currency: Disinvestments or high selling activities of foreign

investors particularly FII’s can slump the markets and also devalue the home
country’s currency as the demand of the home country’s currency reduces
significantly thereby leading to currency devaluation.

d) GDP Growth/Inflation: Increased dependency on foreign investors might expose the

country’s economy to the risk of higher inflation and lower GDP growth. Since a lot
of businesses raise capital through IPO’s, venture capital funds which are primarily
backed by foreign investment banks and foreign QFI’s (Qualified foreign investors).
The fund inflows from these institutions helps domestic firms expand their production
capacity and helps them to grow and access to finance through these foreign investors
would be hampered thus affecting the GDP of a country.
There are both pros and cons of the Rajan Committee Recommendation for greater
liquidity in markets. The positives outweigh the negatives because there has to be greater
inflow of funds in the Indian capital markets to improve efficiencies and are imperative
for a growing economy like India. Coming over to the negatives, we need to ensure that
the inflow of foreign funds remain in certain limits which ensures there is no
manipulation in the markets thereby enabling growth and minimizing the risks associated
with greater liquidity in the equity and bond markets.

Q3. “Public sector banks are a disaster waiting to happen and ought to be scaled
down decisively”. Discuss.
Ans: India’s public-sector banks are at a very crucial stage where they are supposed to
remain financially independent without giving up social responsibilities; they need to
undertake risky experiments, yet perform well. India’s banking industry is very
contrasting on one hand it is acting as the growth driver of the world’s fastest growing
major economy, and on the other, is grappling with challenges of mounting bad loans,
deteriorating asset quality and decelerating core business activities, which are threatening
their future growth prospects. Public sector banks received a lifeline of Rs 2.11 Lakh
Crore from the government for recapitalization seeking to stimulate the flow of credit to
spur private investment. Public sector banks although performed badly in the past, but
after this influx of recapitalisation capital, Public Sector Banks might prove a game
changer in the Indian Banking Industry. Some of the key developments and challenges
are discussed below:

Rising NPA’s:
The most grievous among them is the increasing burden of distressed loans. According to
the Reserve Bank of India (RBI), the value of banks’ gross non-performing assets
(GNPA) and restructured assets reached $150 billion in April 2016 and has been growing
by almost 25% annually since 2013. The public-sector banks account for more than three-
fourths of the stressed asset load. Provision levels are inadequate to bring in an
immediate solution to this problem.

Falling Recovery Rate:

What is probably more disturbing is that the recovery rate has been falling over the years.
Data from the RBI show that in 2015-2016, the recovery rate fell to 10.3% of the net
NPAs. In 2014-2015, it was at 12.4%. In 2013-2014 and 2012-2013, the recovery rates
were even better at 18.4% and 22%, respectively. The public-sector banks account for
more than three-fourths of the stressed asset load. Not surprising since the public-sector
banks are more exposed to industry sectors with a higher share of non-performing loans
than their private-sector counterparts. These state-owned institutions have deep networks
and control 70% of banks’ asset base.
Optimistic Growth:
In India, public-sector banks control nearly 80% of the banking industry. Total credit
extended by India’s scheduled commercial banks (SCB) went up to Rs 64,998 billion by
2014-15 from Rs 19,312 billion in 2006-07. The public-sector banks, have been the prime
driver of this growth. In the last five years, between 2010-11 and 2015-16, the aggregate
credit advances of the public-sector banks have increased by about 65%. Aggregate
deposits of the public-sector banks have grown 66.3% during the same period from
Rs 27,078 billion in 2010-11 to Rs 45,019 billion in 2015-16.

Falling Credit-Deposit Ratio:

The growth of deposits and credit has, however, witnessed a decline in recent years.
The growth of credit off-take has been affected seriously during the last two years
causing a fall in credit-deposit ratio. The credit-deposit ratio of the public-sector banks
has declined by about one percentage points in the last four years from 77.85% in 2012-
13 to 74.72% in 2015-16. The situation worsened in 2016-17 due to demonetization and
is reflected in the lower growth in credit off-take compared to that of deposits. According
to RBI data, the deposit and credit growth of nationalised banks declined to 6.5% and
0.6% in the January-March 2017 quarter as compared to 11.6% and 2.9% growth in the
previous quarter.

Public sector banks might not prove to be a disaster waiting to happen after the injection
of fresh capital from the Indian government which would give provide them with a
cushion against their NPA’s and they can focus on lending and other banking activities. It
will be interesting to see how Public-Sector Banks revive and compete fiercely with their
private counterparts.

Q4. “A move towards the principle-based regulation paradigm is an unquestionable

need for India”. Discuss.
Ans: The two major approaches to regulation are 'rules based' and 'principles based or
outcome based regulations’. India currently operates on a rule based regulation paradigm.
Rule based regulation sets out the processes which a regulated entity is supposed to
comply with, and is not directly concerned with the consequent outcome. Firms then try
to find clever ways to comply with the letter of the law, but defeat the purpose of the
rules.

Rule based regulation draws regulators into an endless war, where the industry will
always tend to invent ways to mould the rules. It creates an unhealthy tension in the
relationship between regulators and the industry. In addition, rules tend to rapidly become
obsolete with the constant evolution of technology and processes. Government has to
keep modifying the rules, catching up with new thinking in the industry.
The alternative to rules-based regulation is principles-based regulation. Law based on
principles is not new. A large number of our older laws have been based on principles.
These laws do not specify a method or process that an entity must approach but lay down
the guiding principle that it must follow.

The new SEBI regulations on advertisement reveal a shift towards principles-based

regulation. For example, a regulation reads:

In audio-visual media based advertisements, the standard warning in visual and

accompanying voice over reiteration shall be audible in a clear and understandable
manner. For example, in standard warning both the visual and the voice over reiteration
containing 14 words running for at least 5 seconds may be considered as clear and
understandable. (emphasis added).

Instead of mandating that the warning should be at least 5 seconds long, as would have
been done with rules-based regulation, it is stated that that it must be audible, clear,
understandable. The 14 words in 5 seconds is now not a legal requirement: it is only an
illustration of how the principle can be satisfied.

Principles based regulations have two major advantages over a rule based system:

 The regulations require the regulated to strive towards an outcome and not
mechanistic compliance.
 The regulations allow for innovation to be absorbed quickly by the industry as
long as they meet the objective of the regulation.

Moving to a principle based system is a crucial step forward, away from the command
and control mindset that many regulators suffer from. Instead of prohibiting malpractices,
all too often, laws in India micro-manage the regulated business. This is a recipe for
stagnation.

However, principles based financial regulation also has costs.

a) Rules are black and white where there is legal certainty. With principles based
regulation, the precise nature of a government response to a new idea by the
private sector is less predictable.

b) More complex behaviours are, then, required of the regulator. More litigation will
arise. This will impose a greater burden on staff in regulators, courts and law
firms. They will need to understand principles (and their underlying drafting
intent), alongside practical knowledge about how the real-world works, so as to be
 able to intelligently apply the principles. This requires a great deal of
understanding of technology, business and regulatory objectives.

c) Moving towards a principle based system requires commensurate strengthening of

organisational and staff capabilities at SEBI, the Securities Appellate Tribunal
(SAT), and the Supreme Court.

Therefore, taking into account the maturity level of the Indian financial system rule based
regulation must occupy a dominant position while principle based regulations acting as a
complementary regulatory framework must be backed with effective supervision.

Submitted By:
Parang Mehta
20142043
BBA MBA
(2015 – 2020)