Articles and Commentaries |
May 5, 2021

Financial Sector Reforms – A Propellant for New India

Written By: Ranvir Singh

When the Central government was re-elected for its second term in 2019, it was clear that economic reforms would be at the top of its agenda. Its first term was marked by a number of socio-economic measures, including the Pradhan Mantri Jan Dhan Yojana and the Pradhan Mantri Mudra Yojana. It pushed for reforms with its ‘Make in India’ initiative and the opening up of FDI in several sectors. Among its bolder initiatives were GST, demonetisation, and the overhaul of our antiquated labor laws. There are several notable achievements that really transformed the macroeconomic environment and improved socio-economic indicators.

Government has taken several initiatives to create right enablers and stability for the economy. These reforms are inextricably intertwined with financial sector.

  • Adoption of GST: It was a herculean task to bring a pan-India structural tax reform that is so encompassing and transformative from Day 1. Under the adept leadership of the then finance minister Mr Arun Jaitley, these reforms could see the light of the day. The enabling mechanism was provided by the enactment of the Constitution (One Hundred and First Amendment) Act, following which Parliament enacted four Central laws. Further, all the 29 States enacted enabling laws in their Assemblies, while the Centre notified it for all the seven Union Territories. The GST replaces eight Central taxes and nine State taxes. The subsequent refinements in the GST rules and delivery mechanisms have really enabled enterprises of all levels to reap the dividends in the long term.
  • Reduction of Corporate Tax: One of the first measures taken by the government in its second term was to slash corporate tax by almost 10%. The concession in tax rates is expected to provide fillip to the Make in India campaign, boost employment, and attract more investments[i]. Its current tax rates also puts India at par with its Asian peers.
  • One of the signature reforms of the Central government in its first term was in amending insolvency laws in 2016. This bold step was long-needed to modify India’s often brutal and impractical bankruptcy regime. The Insolvency and Bankruptcy Code (IBC) aims to consolidate and amend the laws relating to reorganisation and insolvency resolution in a time-bound manner. According to the World Bank, against the 2016 world average of 2.5 years to resolve insolvency, it took Japan 0.6 years, Singapore and Canada 0.8 years, the US 1.5 years and China 1.7 years. The figure for India: 4.3 years. IBC will help address this disparity and bring swiftness in handling the battered companies.
  • On ease of doing business, several initiatives have already been taken by the Government, which has helped India went up by 14 points in the World Bank’s Ease of Doing Business 2020 survey to be placed at 63rd position among the 190 countries. It is certainly indicative of the Centre’s relentless efforts to create a more investor and business-friendly environment in the country in its first term in power. Other than simplifying the tax regime through the revolutionary GST, the government has also made the tax structure more conducive to growth. For tax disputes and litigations, the government launched ‘Vivad Se Vishwas’ scheme. It is expected to aid direct tax collection by providing an avenue to address any disputes. The other significant measure in this endeavour has been the hike in FDI across different sectors. It has opened up investments, infusing capital and increasing the competition in the market.

The Government’s second term promised to continue with its bold reformist legacy. In his second term, Prime Minister has set a very ambitious goal to reach 5 trillion dollar economy by 2024. However, the pandemic has thrown a spanner in the works, forcing the government to focus on immediacy. The economy now needs a real push to catapult itself to the desired growth path at this critical juncture that is slated to be the defining moment of the Indian economy. However, a set of measures in financial sector across five key areas – “Financing Infrastructure”, “Continued focus on banking sector reforms”, “Strengthening Financial Intermediation with Aadhar, UPI and PMJDY”, ‘Promoting Fintech”, and “Realising the full potential of agriculture sector reforms” – will be critical for growth.

Financing Infrastructure

In line with the announcement made by the Prime Minister in his 2019 Independence Day speech, the Finance Minister, in her press conference on December 2019, announced a major push in the infrastructure spending for over Rs. 102 lakh crore over the current 5 year term. One can’t underscore the importance of the role of financial lenders and institutions in enabling the long-term growth in these projects. While physical capital creation through capital expenditure (or capex) enhances the total factor productivity (TFP), there is empirical evidence of physical infrastructure enhancing the overall business environment and competitiveness of an economy.

The Union Budget 2021-22 of the Government of India proposed the setting up of a new Development Finance Institution (DFI). In keeping with this, the Budget Session of Parliament will now consider a new bill titled, “The National Bank for Financing Infrastructure and Development (NaBFID) Bill, 2021,” to set up a Development Financial Institution (DFI) for the purpose of funding infrastructure projects and their entire ecosystem across their lifespan. In line with the other sector-specific DFIs such as NABARD, EXIM Bank, SIDBI, REC, the current DFI should help provide the capital expenditure for the infrastructure spree that our nation intends to follow for the next several years. To promote investment in the infrastructure projects:

  • The need is for liberalised financial markets, deepening and widening of local markets, wider use of risk management and other financial products. There is a need to have a more robust yield curve across different tenors. This will entail not only developing the term money market but also secondary trading in long term bond market. This can help create derivatives for hedging across different maturity periods, and also improve monetary transmission in India.
  • Strengthen legal frameworks and accounting standards with the usage of new and alternate structures. For example, with the Bilateral Netting of Qualified Financial Contracts Act, 2020, to enforce close-out netting for bilateral financial contracts in India. This will help in development of the over-the-counter (OTC) derivatives market. This will lead to efficient margining system for such OTC derivatives and facilitate productive use of bank funds. It will also act as a catalyst for corporate bond market by wider acceptance of the credit default swap market.
  • Tap institutional sources, such as pension, provident and insurance funds that have the advantage of providing a better maturity match for infrastructure financing. These funds could also be allowed to deposit in banks for long periods, subject to banks using them exclusively for infrastructure financing. Further, banks should be permitted to float 10 to 15-year tax-free bonds. With the right framework, large banks with strong balance sheet should be allowed even to float over 30-year bonds.
  • Conditions should be created whereby savers are attracted towards investing in long-term debt instruments. In the absence of secondary market, most instruments are currently held to maturity. This keeps many investors away such as retail investors. In addition to development of secondary markets, government should asses issuance of bonds which can provide part or near-full inflation hedges.
  • Opening up FDI in the insurance sector to meet dual objective of infra financing and enhanced customer penetration. It allowed up to 74% FDI in the insurance under the automatic route, up from the previous cap at 49%. This should go in tandem with Insurance Regulatory and Development Authority (IRDAI) driving policies that can help drive more investments in long term assets while providing the right safeguards for hedging of market risks linked to such investments
  • The proposed DFIs should be able to reduce complexities associated with the large-scale capital expenditures and should create structures which can help propel an otherwise struck project. The instrument of take-out financing be leveraged adequately while working in conjunction with banks and other financial institutions, who may have appetite to lend for 3-5 years as against the requirement of 15 years for infrastructure.

Continued focus on banking sector reforms

  • On 30 August 2019, the government announced a key decision to merge ten banks into four entities. The objective here is to improve the operational efficiency and upgrade the health and financial soundness of the Indian banks, especially Public Sector Banks (PSBs). Further to building transparency and improving accountability, while presenting the Union Budget, Finance Minister Nirmala Sitharaman had announced the privatisation of two public sector banks (PSBs) and one general insurance firm by 2021-22. This should reduce the drag on the government coffers in the form of infusion for bank recapitalisation, which is expected to be Rs. 20,000 crore in FY 2021-22. As the Government has intended to reduce its stake to 33% in public sector banks, it will further add to private investments in the banking sector and will help drive the agility and efficiency which is required for the new-age banks.
  • After the Banking Regulation (Amendment) Bill, 2020, the chances to have occurrences of frauds seen in the case of PMC Bank is significantly mitigated. In the absence of the current bill, it was allowed that cooperative banks, without the oversight of RBI, could use the same banks to solicit deposits from the customers. The new law makes a concerted attempt at bringing such banks under the regulatory oversight of the RBI. The Central Bank will now have the right to approve the appointment of auditors and recommend removal of auditors to these cooperative banks with the intention of improving their governance and also timely identification of any financial vulnerabilities to prevent a future crisis. RBI should continue to act as a legal guardian of fair play in such situations. The prompt action from RBI will go a long way in signalling the stability of banking sector, as is the case with commercial bank, Yes Bank, in which the functioning was restored without loss of depositor’s money after the management changes and other corrective actions were taken promptly.
  • The issue of NPA management is not only for the sake of strengthening a particular bank, but also for ensuring the NPA overhang doesn’t stop the flow of credit in sectors that imminently require. The recent Budget has proposed setting up a ‘bad bank’ to help process the NPAs out of the balance sheet of banks. A bad bank will help streamline the operations of the primary bank by buying NPAs at deep discounts. The banks should be equipped with NPA management capabilities by applying the right regulatory and procedural strategies at their disposal. With a tepid credit offtake in industry and services sector, and strong growth in deposits, the banking sector seems to be in a state of abundant liquidity, while this liquidity is not translated in the commensurate credit growth. And in the absence of setting up of such ‘bad banks,’ there will be overhang of NPAs that will stress inflows, thereby leading to solvency risk. It is the opportune time to provide allowance in capital adequacy norms and allow space for banks to clean up.

Strengthening Financial Intermediation with Aadhar, UPI and PMJDY

The reforms have little meaning if they don’t touch the lives of people who, perhaps, need the most. Though, there are numerous initiatives which have helped deepen financial inclusion, there are three of them which has created the right enabler for drive revolution in financial inclusion. These are linked to adoption of Aadhar, UPI and Pradhan Mantri Jan Dhan Yojana (PMJDY). Government should continue to provide opportunities for private sector to use these enablers for a deep-rooted financial inclusion in India.

  • To help identify the targeted beneficiaries for wealth distributive policies and social security schemes, Central Government enacted the Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act. Today, Aadhaar has become India’s most credible identity currency. It is effectively used in linking direct benefits such as the public distribution system, employment guarantee schemes, etc. For the lower income segments, the data on direct benefits can be used to provide better financial inclusion, such as offering credit and insurance products.
  • Within the first few months into the term, Government started with a major financial inclusion program—Pradhan Mantri Jan Dhan Yojana—to bring millions of underbanked and unbanked customers within the financial inclusion ambit, empowering them to avail services like DBT (Direct Benefit Transfer), social security schemes like insurance and pension. Under this scheme, 15 million bank accounts were opened on inauguration day, a global record for the most bank accounts opened in one week as a part of the financial inclusion campaign. As Government embarks on this journey, there is a need for more formalisation in the unorganised sector especially in rural areas where schemes such as Jan-Dhan Yojana are popular. This has helped raise awareness of new banking products. More importantly, this should be promoted for banks and emerging fintech companies to offer products such as unsecured personal loan, supply chain financing, life and health insurance, etc.
  • The world can be divided into two types of people – type 1 who have used UPI and type 2 who have not. Though, in this era of data and technology, as many minor and major innovations happened, UPI was a trailblazer. The scale of UPI impact has been gargantuan. UPI has revolutionised the payments system completely inter-operable across all payment systems removing simplicity arbitrage by enabling one click two factor authentications. It has catalysed high volume, low-cost payments, creating a new ecosystem that billers/billers may adopt without needing a Point of Sale (POS) systems at millions of merchants. UPI recorded[ii]73 billion transactions in March 2021 and the value of transaction has surpassed the 5 lakh crore mark. Several large global financial houses have applauded the strong foundation created by UPI upon which private players can ensure innovation. And after the fabulous success of UPI, we now have a highly modernised payments infrastructure that has helped us achieve greater financial inclusion than those achieved by the other developing economies. The appreciation towards the modern Indian payment infrastructure has even been echoed by leading technologists and large billion-dollar enterprises’ CEOs. Moreover, several central banks in the southeast Asia and other parts of the world are taking inspiration and drawing up plans to build a payment infrastructure as robust as UPI by working with the technocrats of National Payments Corporation of India (NPCI) and UIDAI.

Promoting Fintechs

Silently, yet not surreptitiously, a new breed of companies started calling the shots, unerringly and harmlessly named Fintech – a broad brushstroke of FINance and TECHnology. They are adorned with Machine Learning and Artificial Learning techniques. Though, their lofty over-usage has cheapened the anchorage of these words, though every day they bring new tidings and death-knell for old form of retail banking. James Baldwin, once talking about power of dialects and patois, said,

To open your mouth in England is to ‘put your business in the street’: you have confessed your parents, your youth, your school, your salary, your self-esteem, and, alas, your future.

Perhaps the same can be said about the power of “digital footprint”, with much higher intensity and much better precision. Unlike Fintech, traditional banks had been both timid and tentative in using data. The soft pleasure of meeting the customer before granting loan, seeing them from head to toe with disbelief comes naturally to Indian senses. Packed with data from everywhere – bureau, social media, digital footprint, mobile, self-declared, purchase data, data of associates, sometimes associate’s associate, etc. – Fintech are increasing becoming wiser. They use whole host of data models – credit risk model, propensity for pricing model, loyalty model, etc. using variables tested and developed with experience.

For now, fintech are driving innovation in almost all areas of finance – lending, saving product, protection needs in the form of life insurance, health and general insurance, micro-payments, transaction services, etc. With over 400 million internet users and over 1.1 billion mobile phones, reforms are required that bring in more transparency and usage of advanced tools and technologies. The aim should be to provide the end-user with a superior experience with greater convenience, and enhanced security. To promote, the fintech industry, the three things which are critical is availability of risk capital, presence of public infrastructure, and ease of doing business.

  • On availability of capital, there is a need to create the right market mechanism. This will involve an automatic route approval in fintech and linked companies. Government should assess having an 100% FDI norm for fintech with investments of less than Rs. 500 crore. Currently, the market for debt funding is invariably non-existent for small fintech. Government should set-up the framework for more capital flow directly as debt to fintech or through a market mechanism such as venture debt framework. For this purpose, Government can also consider setting up a Rs. 5000 crore fund for providing venture debt for emerging fintech.
  • Simplification and digitisation of know-your-customer (KYC) norms will help start-ups offer their services across geographies. They can cater to diffused demand due to the inherent anytime-anywhere-accessible nature of online systems. Further, for financial inclusion, framework for paperless and presence-less onboarding should be developed. To avail the full benefit of Aadhar, UPI and bank account, Government should ease the norms for KYC, while working in conjunction with RBI for a wider coverage digitally. With the new remote customer authentication option, the service providers need not physically reach out to customers in remote locations aiding in cutting down the costs significantly, and KYC norms should be achieved using face-matching software and AI.
  • A separate regulator for fintech should be assessed. With varied product offerings and heavy usage of data, the need for compliance and regulations cannot be emphasised much. A specialised body under RBI to regulate fintech could not only help operate efficiently in a more organised manner and meet compliances more easily, but could also significantly aid innovation and experimentation. It will also check for potential instabilities on account of unbridled growth, and can avoid illegal practices such as the recent online loan scam. It will contribute significantly on addressing customer grievances too.
  • Government should also evaluate emerging themes such as regulation of cryptocurrency and comprehensive outlook on crypto trading. This is critical for ensuring any potential instability coming from alternate monetary units are well managed
  • In terms of addition benefits to the industry, there are a series of measures which can be deliberated before translating into policy. For example,
    • the abolition of Long Term Capital Gain (LTCG) tax can help remove the deterrent which low to mid income households face in investing in equities.
    • Relaxation under FEMA to help fintech offer products to people outside India. This should cater not only to people of Indian origin or Indians staying abroad but even the global customers who may have interest in Indian products
    • Support with digitisation of banks, particularly regional banks and cooperative banks which can help partner with fintech better

Realising the full potential of Agri sector Reforms

The boldest reform by the government is undoubtedly the agricultural reforms it introduced in May last year. The long-overdue reforms, aimed at agriculture and allied sectors, will benefit both the farmers and the consumers. Among the slew of measures, the three most important steps were the announcement of an outlay of INR 1.63 lakh crore, amending the stringent Essential Commodities Act (ESA), and offering farmers the freedom to sell their products at any market of their choice[iii].

The farm laws removed inter-state trade barriers and allowed for e-trading in agricultural produce. They have the potential of revolutionising the agricultural sector by removing the hegemony of regional mandis. It also opens up the market to participation by the private sector, providing an immense opportunity for farmers to tie up with private players. The relaxation of ESA also frees up more commodities for fair trade. It can help market forces play an overarching goal in ensuring crops get the right prices, stable food inflation, strong growth in farm sector and allied sectors contribution to GDP, improve FDI in the agricultural focused start-ups, streamline the marketing of agricultural produce and boost the rural economy.

On the financial sectors, there are several measures that can help drive and augment the full benefit of agriculture reform. A slew of measures in financial sector should go in tandem for financial intermediation across the full value chain—farmers, traders, warehouse provider, processers, Custom Hiring Centres (CHCs) providing irrigation pumps, tractors, other mechanisation tools, other input providers, etc.

  • Government should plan for expanded and broad-based definition of Priority Sector Lending (PSL). Currently of the 40% of banking asset earmarked as PSL, the direct agriculture is 13.5%, while 4.5% is indirect agriculture and rest includes other categories. Most of the new element will fall under indirect. We need a more expanded definition of indirect. In fact, indirect should be expanded to include at least 10% of PSL. PSL definition should also include agri-ecommerce companies, warehouse providers, processors or aggregators at farm gates.
  • Government should leverage SIDBI and other institutions to drive refinancing and creation of SMEs in agriculture sector, particularly catering to new segments which will become critical as the agriculture reforms plays out. Further, an equity fund to be created to have direct investments in agriculture sector. For efficient dissemination of equity investment, this can be achieved via “Funds of Funds” structure.
  • The secondary market for PSL papers with enhanced definition of PSL will provide a more market-friendly funding for large investments in warehouses, cold storage, processing capability, input requirements in terms or mechanisation, etc.

In summary, the government is on the path to stabilise the economic growth post the pandemic and is not shying away from taking even further bold efforts. These reforms will go a long way in shaping a more conducive regulatory setup for growth of our financial sector and for safeguarding the rights of different participants in our financial system.

Author Brief Bio: Ranvir Singh is the Managing Director and Founder of Kissht (leading fintech in India). He is an Alumnus of IIM-Bangalore and IIT-Bombay, and was an Associate Principal at McKinsey& Company prior to starting Kissht.





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