India’s financial sector is facing several challenges. One is to put in place a new regulatory architecture which has provoked animated debate already. A Financial Sector Legislative Reforms Commission (FSLRC) has submitted its report on a comprehensive regulatory structure for the financial sector and its recommendations have been contested in various quarters including by the Reserve Bank.

The second issue for the financial sector is to nurture and develop the various segments of the financial markets to meet the funding requirements of growing Indian economy.

A third aspect is the huge capital requirements of India’s public sector banks for their stability. The banks’ capital requirements have been examined at various levels from national to global bodies looking into overall financial stability in the light of experience post the financial crisis.

The budget has looked at all these issues and tackled these at different levels of implementation. Admittedly, these budget provisions are not the final words on each of these issues and they represent actually “work-in-progress”. Let us look at these.

Finance minister has promised to implement the recommendations of the FSLRC at the earliest, including the one for enactment of a proposed Indian Financial Code. The minister promised adequate consultations with the stakeholders before formulating such a code to take care of competing interests.

At the same time, finance minister must take adequate note of some reservations raised by the Reserve Bank governor, Raghuram Rajan, on some of the recommendations. Governor Rajan has particularly raised his objections on heightened powers of judicial review of the powers of financial sector regulators.

In a recent address at the first State Bank Banking and Economics conclave, Mr Rajan spelt out his two points of what he called “tensions”. One was the oversight of regulators. Although the FSLRC did not suggest laws that micromanage, giving regulators the freedom to fill in the details in consonance with the changing needs of the economy, it would still want to check and balance the activities of regulators through judicial oversight.

“Too much of checks and balances could completely vitiate the flexibility afforded by rewriting laws. We need to find a proper balance, and the balance may vary with our level of development. I worry we have not thought through this fully” the governor observed.

The second area of tension was the appropriate size and scope of regulators. Mr Rajan called the FSLRC recommendations “somewhat schizophrenic here”.

His criticisms are sharp and it is better to quote exactly: “On the one hand, it emphasizes synergies in bringing together some regulators into one entity. But in the process it suggests breaking up other regulators, with attendant loss of synergies. There is no discussion of the empirical magnitude of the synergies gained or synergies lost, which makes the recommendations seem faddish and impressionistic rather than based on deep analysis. Indeed, across the world, we see a variety of organizational structures in existence, suggesting that there is no one right structure. If so, there should be strong arguments for departing from the status quo, which the FSLRC does not provide.”

These are very strong criticisms coming from the head of an institution which has stood the test of time as an effective and judicious regulator of the banking sector. Any hasty action there would be rather destructive and the finance minister should better err on the side of caution than urge to introduce something new.

The budget also has taken several steps for further developing the financial markets for corporate bonds, the various depository receipts and grant tax reliefs for facilitating financial transactions. These are useful interventions and could help the growth of financial markets and better price discovery for various financial products. Of these, development of a corporate bonds market is extremely useful since Indian corporates do not have access to an effective debt market for raising finances.

This is important as equity capital may not be the more useful way of raising funds. Equity imposes a long term burden on a corporate whereas a debt in the form of a corporate bond could be for a limited period. The overall long term costs of such an instrument could be cheaper and it provides flexibility. This is a welcome move.

As regards recapitalisation of Indian PSU banks, the finance minister’s proposal for allowing them to tap the domestic retail investors with equity offers is a sound suggestion. After all, issue of equity shares to resident Indian public in the PSU banks would give them an avenue for investment.

However, going by the trends in prices of public sector banks vis-à-vis their new private sector counterparts, is rather disappointing. This is because of two principal reasons. First, the public sector banks have been burdened with directed lending. This is not only what they have to give under say priority sector obligations, but also to distressed industries under government directions. One recent such example is the government direction to PSU banks to provide Rs 4400 crore to beleaguered sugar industry this crushing season to enable them to purchase sugar cane.

No wonder these interferences hobble the banks with unproductive assets and create pressure on their balance sheets. A related issue is the large non-productive assets portfolio of PSU banks. With general economic downturn, the banks assets in the form of loans to industrial sectors which are not doing too well, have turned unproductive. These also weigh on their value.

To attract investment in their shares, the PSU banks need to be freed from such government interference. They should be made more independent and their board professionalised. They must learn to function in ways that is reflected on their share values. Then only their share issues would be attractive.

The finance minister has made welcome announcements in his budget. But he will have to work on them to make his programme a success. (IPA Service)