CHAPTER-3

THE HISTORICAL GROWTH

OF THE
INDIAN MONEY MARKET
3.1 FEATURES OF INDIAN MONEY MARKET

The Money Market is a market for short-term money and financial

assets that are close substitutes of money. Money market exists anywhere

borrowers and lenders desire to enter into short-term credit transactions as

in any other market. Money market also has three constituents like any

other market - (1) It has buyers and sellers in the form of lenders or

borrowers, (2) It has a commodity in the form of instruments like Treasury

Bill and Commercial Paper etc. (3) It has a price in the form of rate of

interest.

The term “Money Market” refers to the various firms and

institutions dealing with various types of “near money”. Near money

consists of assets which can be converted into cash without loss.

One of the feature of money market is that it is not one market but

the collection of markets such as call and notice money market and bill

market etc. All these markets have close inter-relationships.

An ideal money market is one where there are large number of

participants. Larger is the number of participants, greater is the depth of

the market.

Almost every major economic body like the corporate body, a

Government body or a financial institution like RBI, LIC and Bank has a

regular problem of liquidity management. It is only the money market

 43

which solves this problem. If the problem is that of cash out flow in excess

of cash receipts, they go to the money market looking for funds. If the

problem is that of excess cash inflow, it is again to the money market that

they run for temporary fund deployment. Thus it is the money market

which meets short-term requirements of borrowers and provides profitable

avenues to the lenders.

The money market is a wholesale market. The volume of funds,

representing money traded in the market, are very large. There are skilled

personnels to undertake the transactions. Trading in the market is

conducted over the telephone followed by written confirmation from both

the borrowers and lenders.

Depending on supply of funds, Indian Money Market is divided

into two markets: (a) The organized money market (b) The unorganized

money market.

The participants in the organized money market are the Reserve

Bank of India (RBI), Commercial Banks, Co-operative Banks, Unit Trust of

India (UTI), Life Insurance Corporation of India (LIC), General Insurance

Company (GIC). Discount and Finance House of India (DFHI), Industrial

Development Bank of India (IDBI), National Bank of Agriculture and Rural

Development (NABARD), Industrial Credit Investment Corporation of

India (ICICI), Corporate bodies. The RBI has close links with money
 44

market and it can justly be regarded as an important constituent of money

market as it plays the vital role of controlling the flow of currency and

credit in the market.

The unorganized sector consists of indigenous bankers who

pursue the banking business on traditional lines. These indigenous bankers

follow their own rules of banking and finance. Attempts have been made

by RBI to bring them under the organized market. But indigenous bankers

as a whole have not accepted the conditions prescribed by RBI.

The instruments in the money market are call money, Treasury

Bills, Commercial Bills, Commercial Paper, Certificate of Deposits,

Interbank Participation.

A very striking characteristic of Indian Money Market has been

the seasonal monetary stringency and high interest rate lending during the

busy season.

Money market has two strata: (a) the primary market and (b) the

secondary market.

Where the lenders and borrowers directly deal with money or

through brokers it is known as primary market. To make the instruments

more liquid, the secondary market has been built up. Discount and Finance

House of India Ltd. has been set up by the Reserve Bank of India to provide

an active secondary market for money market.

 45

In order to enable the small investors to get access to the money

market so as to benefit from its yields, the Reserve Bank of India has issued

broad guidelines to allow banks and the subsidiaries to set up Money

Market Mutual Funds (MMMF) similar to mutual funds for stock market.

MMMFs pool the investors funds through MMMF Unit/deposit account and

invest this fund in money market instruments.

With the liberalization, and deregulation process initiated by RBI,

several innovations have been introduced. But even then the money market

is not free from the following rigidities:

1. Absence of integration

2. Disparity of interest rates in different centres

3. Resistance of the unorganized money market

4. High volatility

5. Restricted/Limited number of players

6. Limited number of instruments

7. Absence of transparency in transactions

8. Inefficient payment system

Efficient Money Market: The Conditionalities

1. Political stability in the country.

2. Presence of highly organized commercial banking system.

3. Effectiveness of central banking authority.

 46

4. Existence of efficient payment system.

5. Book entry system, delivery rather than payment system for ensuring
risk free and transparent settlement.

6. Existence of demand for temporary surplus funds.

3.2 HISTORIGAL BACKGROUND OF MONEY MARKET

Call money market is the oldest in the history of money market in

India which provides the^nTstitutional arrangement for making the

temporary surplus of some banks av&iRible to other banks which are

temporarily in short of funds. The rate of lifterest paid on call loans is

known as the call-rate. The call rate in India was used to be determined by

market forces till 1973. Due to the credit squeeze introduced by RBI in

May, 1973 in the form of raising the bank rate and tightening of refinance

and rediscounting facilities, the call rate had reached as high a level as 30%

in Dec., 1973. Due to this alarming level of call rate it became necessary to

regulate it within a reasonable a limit.

Therefore, the Indian Bank Association in 1973 fixed a ceiling of

15% on the level of call rate. Since the IBA has lowered the ceiling of 15%

to 12.5% in March 1976, 10% in June 1977, 8.65 in March 1978 and 10% in

April 1980. In India the call rate has always exceeded the bank rate except

in the freak year 1955-66. The difference between two rates increased as

the RBI tightened its refinancing and rediscounting facilities till 1975-76.
 47

In 1980-81, the call rate was much higher than the bank rate. After 1981,

call rate was slightly higher than the bank rate.

After Discount and Finance House of India (D.F.H.I.) commenced

its operation in April 1988, it was permitted by R.B.I. to act as an arranger

of funds in the call market. However, with effect from 28th July, 1988, it

has been allowed to participate both as the lender and as borrower in the

call notice market. The call rate has oeen freed from administrative ceiling

in 2 stages.

i. Effective from October, 1988, the operations of D.F.H.I., in

the call market were exempted from the ceiling on the call

rate.

ii. With effect from. 1st May, 1989, the ceilings in the call rate

and inter-bank term money rate were withdrawn. As a

result, the call rate was freely determined by the forces of

demand for and supply of call loan. There are now 2 call

rates in India one is the inter-bank call rate and the other is

the lending rate of D.F.H.I. in the call market.

The Bill Market Scheme was introduced by RBI in January 1952,

Before 1952, the banks were getting additional cash from RBI by selling

their government securities. But now according to bill market scheme, a

bank can grant loan to its customers against their promissory notes and it
 48

can use the same promissory notes to borrow from the Reserve Bank. All

that the Bank is required to do is to convert these promissory notes into

usance promissory notes maturing within 90 days. Initially it was restricted

to (a) the schedule bank with a deposit Rs.10 crores and above, (b) loans

with minimum limit of Rs.10 lakhs (c) individual bills, the minimum value

of each being 1 lakh rupees.

The scope of the scheme was broadened from time to time.

a. by making more banks eligible to borrow under the scheme

b. by reducing the minimum limit of advances.

c. by reducing the minimum eligibility value of bills.

d. by extending the scheme to export bills with minimum usuance of

180-Days.

The bill market scheme became so popular that the turnover under

the scheme increased from Rs.29 crores in 1951-52 to Rs.228 crores in

1955-56 and to Rs.1354 crores in 1968-69. In 1970, RBI instituted

Narashimham Committee to study the development of the bill market. In

1970, the new bill market scheme was introduced under sec 17(2) of the

RBI act.
 49

The Main Features of new Bill Market Scheme

1. All licensed scheduled commercial banks including the public sector

bank are eligible to offer bills of exchange to RBI for discounting.

2. The bills covered under the scheme must be genuine trade bills

relating to the sell or dispatch of goods.

3. RBI rediscounts this bill. That is why the scheme is also called bills

rediscounting scheme.

With effect from April 1972, the Bills of Exchange drawn and

accepted by the Industrial Credit and Investment Corporation of India

(TCICI1 were also made eligible for discount under the scheme. With a

view to making bill financing attractive interest rate on bill rediscounting

for categories subject to the maximum lending rate has been fixed at a rate

1% point lower than the maximum lending rate from 1987. In order to

attract additional funds into rediscount market the ceiling on the bill

rediscounting rate has been raised from 11.5% to 12.5%. Access to bill

rediscounting market has been increased by selectively increasing the

number of participants in the market.

In August 1989, the Government exempted the stamp duty on .

usuance bill.
 50

3.3 THE CHAKRAVARTY COMMITTEE REPORT

3.3.1 Terms of Reference

The Sukhomoy Chakravarty Committee was assigned to review

the following of monetary system in December 1982 with the following

terms of reference:

1. To critically review the structure and operation of the monetary

system.

2. To assess the interaction between monetary policy and public debt

management in so far as they have bearing in the effectiveness of

monetary policy.

3. To evaluate the various instruments of monetary and credit policy

in terms of their impact on the credit system. In this context, links

among the banking sector, the non-banking financial institution

and the unorganized sector could be assessed.

4. To recommend measures for improvement in the formulation and

operation of monetary and credit policy and to suggest specific

areas where the various policy instruments need strengthening.

5. To make such other recommendations as the committee may deem

relevant for effective operation of monetary and credit policy.

/
\

51

3.3.2 The recommendations

The Committee was formed in Dec., 1982 and they submitted

their report in May 1985. The major recommendation of this committee

were broadly as follows:

1. Keeping deficit financing within safe limits.

2. Financing of plans through non-inflationary means.

3. Restructuring of interest rate.

4. Modification of credit appraisal system.

3.3.3 Comments

Only the first three recommendations are relevant to the money

market.

The Committee felt that deficit financing by government should

not exceed safe limit. It has pointed out that the government was still

increasing big deficit despite the sharp rise in the saving rate in the country

from 10.2% in 1950-51 to 22.6% in 1983-84 and that this was due to the

overgrowing demands made on government. The committee therefore, felt,

“it is now incumbent on the government to fix safe limits for deficit

financing as measured in terms of Reserve Bank credit to government”.

This implies that planned expenditure should be financed in a non-

inflationary manner by tapping the savings of the public, along with higher
 52

realization from the public sector enterprises and improvement in efficiency

in the revenue collection and by cutting down the public expenditure.

For this purpose and central to these things are the committee’s

other recommendations of overhauling the structure of interest rates,

developing the Treasury Bill (TB) as the main, if not the foremost

instruments in the money market, broadening the money market and making

the credit disbursal framework more broad based.

The committee has expressed the view that better use should be

made of monetary instruments to mobilize the savings directly from the

public and for this purpose has suggested that TB deserves to be developed

as monetary instrument. The idea is that TB may be a short term source of

investment for the investor, but it is a long term source of funds for the

government.

The first step towards making TB more acceptable would be to

move away from an artificially fixed low discount rate to a flexible rate.

This would make the discount rate in TB a pace setter for all other rates in

the monetary market.

Secondly the committee felt that it would be worthwhile trying to

float the present dormant gilt-edged market, government securities without

any coupon rate but at a discount rate appropriate to prevailing market

condition and depending on the maturity profit and implied yield.

 53

It is felt that the upward revision of yields on government

securities along with a shortening of time period will result in attracting

funds in the capital market. The main reason behind this is to reduce any

significant monetization of debt and the consequent increase in Reserve

Bank credit to government i.e. Deficit financing beyond the agreed limit.

In other words it means, as explained in the report, the increased holding of

TB and government securities by the public would reduce the supply of

funds for bank deposit which would reduce bank credit. The advantage in

this suggestion is that this may reduce the RBI credit to the central/federal

governments due to reduction in reserve money (Cash Reserve Ratio and

Statutory Liquidity Ratio) from which credit is advanced to the government.

According to the committee the recommended revision in the

yields on government securities and treasury bill should be seen as a factor

contributing to better efficiency in government expenditure and greater

accountability, as also quantification of the implicit subsidies otherwise

involved in low yields on government securities. The recommended

restructuring of interest rates would also promote the development of the

money market. In this context, the committee has recommended that the

present ceiling of 10% per annum on the interbank call money rate should

be removed and that the call money market should be broad based by

permitting new institutional members to participate in the market.

 54

These commendations made by the committee have a bearing on

the development of the money market. In the restructured monetary system

envisaged by the committee, the TB market, the call money market, the

commercial bill market and the corporate funds market would be expected

to play an important role in the allocation of short-term resources with

minimum transactions cost and minimum delays.

3.4 THE VAGHUL COMMITTEE REPORT

A working group of money market under chairmanship of N.

Vaghul was appointed by the Reserve Bank of India in September, 1986 to

review the Indian money market and make recommendation for the

development of the money market. The group submitted its report in

January, 1987.

3.4.1 The Main Strategies

1. Attempts should be made to widen and deepen the money market by

selective increase in the number of participants so as to ensure adequate

supply of funds.

2. Endeavour should be made to activate the existing instruments and

develop new instruments so as to have a proper mix suited to different

classes of borrowers and lenders.

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3. Attempt should be made to work out an orderly move away from

administered interest rates to market determined interest rate to impart a

degree of flexibility.

4. An active secondary market needs to be created, if necessary, by

setting up new institutions, to impart liquidity to the money market

instrument.

3.4.2 The Recommendations

Based on these strategies the working group made a number of

recommendation out of which the major recommendation are the following:

1. Limited freeing of interest rates in the money market.

2. Activation of existing instruments like Commercial Bill and

introduction of Commercial Paper and Certificate of Deposit as new money

market instruments.

The Vaghul Committee considered the instrument of bill as an

essential part of an active money market. The committee has accordingly

made several suggestions to promote bill culture among trade and industry.

Among the suggestions to promote the use of bills were the following:

1. Lending of discount rate applicable to bill from 16.75% to 15.5%.

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2. Government directive to issue to all public sector undertakings that

payments for all credit purchases made by them should be made in the form

of bill.

3. Penalty for not honouring the bills on due date.

4. Specific stipulation by RBI directing a phased increase in the

proportion of bill acceptances to total credit purchase to a level of 75% by

April 1997.

5. Establishment of a Finance House to ensure emergence of an active

secondary market for bills besides simplifications in the procedure for bill

and discounting.

3. Setting up of a Discount and Finance House of India (Ltd.)

(D.F.H.I.) as a money market institution to enhance liquidity to the money

market instrument.

3.4.3 The RBI Measures

The Reserve Bank of India has taken the following measures to

implement the recommendation of the working group since 1987.

1. With a view to making bill financing attractive to the borrowers, the

effective interest rate on bill rediscounting for categories subject to the

maximum lending rate has been fixed from 1987 at a rate 1% point lower

than the maximum lending rate.

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2. In order to attract additional funds into rediscounting market, the

ceiling on the bill rediscounting rate has been raised from 11.5% to 12.5%.

3. Access to bill rediscounting market has been increased by

selectively increasing the number of participants in the market.

4. 182-Days TB have been introduced in 1987.

5. Since 1987, (C.A.S.) Credit Authorisation Scheme has been

liberalized to allow for greater access to credit to meet genuine demand in

production sector without the prior sanction of RBI.

6. In April 1988, The Discount and Finance House of India was

established with a view to increasing the liquidity of money market

instrument.

7. In August 1989, the government remitted the duty on a usuance bill.

This step removed a major administrative constraint in the use of bill

system.

8. With effect from 1st May, 1989 RBI has ,deregulated the interest

rates of money market with the objective of removing the interest ceiling on

money rates so as to make them flexible and lend transparency to

transactions in the money market.

9. Certificates of deposits (CD) were introduced in June 1989 to give

investors greater facility in employment of their short term funds.

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10. Another money market instrument, commercial paper (CP), was

introduced in 1990 to provide flexibility to the borrowers.

11. In 1991, the scheduled commercial banks and their subsidiaries were

permitted to set up Money Market Mutual fund (MMMF) which would

provide additional short term avenues to investors and bring money market

instrument within the reach of individuals and small bodies.

12. In 1992-93, 364 day Treasury Bill was introduced and auction of

182 days Treasury Bills was discontinued and it was provided that 364 day

Treasury Bills can be held by commercial banks for meeting statutory ratio.

3.4.4 The Comments

1. There has been notable development in Indian money market since

the implementation of recommendation of Vaghul Committee working

group. Indian money market is more and more organized and diversified.

The government trading in various instruments like 182-Days IB, 364-Days

TB, Commercial Bill, Commercial paper, has increased considerably. The

volume of inter-bank call money, short notice money and term money

transaction has grown significantly. After de-regulation of call rates it has

fluctuated from 2% to 12.0% as per demand for and supply of money. At

present scheduled commercial banks, co-operative banks. DFHI are

participating in the money market both as lenders and borrowers of short

term funds, while LIC, UTI, GIC, IDBI, ICICI and NABARD are
 59

participating as lenders. We will study further the institutions and

instruments in the forthcoming chapters.

2. T.K. Velayadham1, while commenting on the Vaghul Committee

report has rightly observed “Quick job but does not seem to be a thorough

one”, The lack of throughness is reflected in the quality of data presented in

the report and its total inadequacy from point of view of supplementing the

recommendations made by the committee. Perhaps it did not have all the

data necessary for a meaningful analysis. The reason being that its tenure

was too short to make this possible. The RBI is responsible for the short

tenure of the committee. It is felt that institution wise/bank wise data were

a basic pre-requisite for formulating recommendations with regard to

further development of the call market. This would have clearly

established whether any bank was a predominant supplier of funds.

Moreover, it would also have given an idea as to what extent borrowing

banks become lender to an other bank, say the State Bank of India.

3. Two other crucial recommendations with regard to further

development of the call market given below do not stand to reason.

(A) The ceiling of 10% fixed by Indian Bank Association (IBA) or call

money transaction should be removed while it should continue in the case

of non-bank participants.

1 Journal of Indian Institute of Bankers - June 2001, comment on Vaghul Committee Report -
T.K. Velayadham, p.46.
 60

(B) Other than L.I.C., U.T.I., the traditional participants in the call

money market, the market, for the time being, should not be open to new

entrants.

These two recommendations together with the predominance of

the State Bank of India group in the call money market has given rise to not

an inter-bank call market but a SBI market. In this situation it may have

been more appropriate on the part of Voghul Committee to recommend

freeing of interest rates side by side with increasing the number of

participants. Another related albeit pertinent question is how the competing

financial instruments outside the banking system would affect deposit

growth of banks. At the macro level there would hardly be any impact as

ultimately funds would flow back into the system. But it is at the micro

level that the adverse effects are felt.

4. The Chakravorty Committee had argued for the abolition of ceiling

and increasing the number of participants in the market. The issue has been

made more complicated by the recommendations of the Working Group that

the ceiling should be continued for non-bank participants like L.I.C. and

U.T.I.

3.5 THE CHANGING ENVIRONMENT

The strategy of SWOT (Strength, Weakness, Opportunities and

Threats) is usually applicable to all business organisations and so also to

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money market. While strength and weakness are internal to an

organisation, opportunities and threats are what the environment holds out.

The Institutional environment is quite complex and highly

sensitive to small changes in economic environment which significantly

influences functional performance of money market. Therefore, a first

requirement for understanding money market operation is knowledge of the

environment2.

3.5.1 Historical Background of the Change

Before studying the Indian money market in the changing

environment of mid eighties and nineties, let us have a bird’s eye view of

the market in pre and post-independent India.

Paper currency was used in India since the beginning of the

nineteenth century. While the volume increased from Rs.ll Crore in 1874

to Rs.1199 Crores in 1948, the circulation increased from Rs.10 Crores to

Rs.ll88 Crores during the same period. The total money supply increased

from Rs.285 Crores in 1935 to Rs.1833 Crores in 1950.

The foundation of modern banking was laid with the

establishment of the three Presidency Banks, namely, the Bank of Bengal

(1806), the Bank of Bombay (1840) and the Bank of Madras (1846). In

1900 there were nine joint stock banks, eight exchange banks and the three

2 Journal of Indian Institute of Bankers - April-June 19900 - Editorial.

 62

presidency banks with Rs.32 Crores deposit which increased to Rs.957

Crores in 1948. In 1921 the three Presidency Banks were amalgamated to

form the Imperial Bank of India. The money market was without a proper

Central Bank of India until 1935 when the Reserve Bank of India was

established.

Around 1950 the Banking System comprised the RBI, Co­

operative Banks, Exchange Banks and Indian Joint Stock Banks. Treasury

Bills were first issued in India in October, 1917. Originally these bills

were of different maturities of three, six, nine and twelve months. The

amount of total TBs increased from Rs.49 Crores in 1919 to Rs.99 Crores in

1948. The interest rates differed from bank to bank as well as from region

to region, the highest being in Madras. The Government securities

increased from Rs. 2 Crores in 1890 to Rs.382 Crores in 1947, the major

players in this market being banks, Life Insurance Company, Princes,

princely states and private trusts.

In the post-Independence and pre 1987 period, the money market

consisted of the following segments/components: (a) the call money market,

(b)the inter bank term deposit, (c) participation certificate market,

(d)commercial bills market, (e) Treasury Bills market and (f) inter­

corporate market.
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The participants during the same period in the call money market

were commercial banks and co-operative banks as lenders and borrowers

and UTI and LIC as lenders. Prior to December, 1973, the interest rate in

call money market was market determined. Subsequently, ceiling was fixed

- 15% in December, 1973, 8.5% in March, 1978 and 10% in April, 1980.

LIC, UTI, QIC and their subsidiaries, ICICI, IRBI and ECGC were

permitted to rediscount bills.

During this period some of the market characteristics of Indian

economy were continuous inflation, increasing internal (fiscal) and external

deficits, industrialization, urbanization and significant structural

transformation. Functioning with these parameters, all sectors of the

economy have undergone significant changes and the money market has

responded to the changes too.

3.5.2 Economic Reforms in 1980s and 90s

The politico-economic background of the financial development

in India has been determined by the nature of our planned and mixed

economic system. The decade of 1980s for the Indian economy marked a

significant departure from the earlier regime of economic development

under controls which lasted for about three decades. In the early stage of

economic development, the use of physical controls was expedient to

 64

achieve the rate and pattern of investments necessary in building up strong

and broad based infrastructure for a self-reliant economy.

As experienced by several other countries, a fast transition from

regulated economy to free one is bound to be traumatic and painful which is

characterized by stagnation, rising unemployment, larger doses of foreign

assistance. Liberalization in India has been carefully managed to avoid

these unpleasant effects and hardships. In India liberalization has been a

process of gradualisation desired to achieve a smooth transition of

economy. The logical extension of industrial liberalization has been the

deregulation in financial markets, foreign trade, foreign exchange and move

towards gradual privatization.

The fundamental philosophy of development process in India has

shifted to free market economics and the consequent

liberalization/deregulation/ globalization of the economy. Major economic

policy changes such as macro-economic stablisation, delicensing of

industries, trade liberalization, currency reforms, reduction in subsidies,

financial sector/capital market/banking reform, privatization/dis-investment

in public sector undertaking, tax reforms and company law reforms in terms

of simplification and debureaucratisation are being gradually implemented

and they have far reaching impacts on the structure of the corporate

industrial sector. In such an emerging economic scenario, the role of

Government in economic management did obviously shrink resulting in

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(I)privatization of financial institution, (II) reorganization of institutional

structure and (III) Investor protection.

3.5.3 Industrial Reforms

By the early 1980s’ when adequate productive capacities were

created in the industry and infrastructure, it was time to review the utility

of physical controls which were acting more as deterrent in the smooth

functioning of economy. The phase of liberalization began with gradual

removal of price and distribution controls on several industrial products as

well as on investment in industries. Industrial liberalization produced

remarkable results with the industrial growth spurting to 8% in 1980s

against 5% in the earlier decade. The favourable impact was also visible in

the agricultural sector which recovered to experience 3.4% growth in

1980s’ compared to 2.1% in 1970s’. Propelling the economy to a higher

growth orbit of 5.5% from earlier trend rate of 3.5%.

Government announced New Industrial Policy on July, 24, 1991.

This new policy deregulates the industrial economy in a substantial manner.

In a major move to liberalise economy, the new industrial policy abolished

all industrial licensing, irrespective of level of investment, except for

certain industries related to security and strategic concerns, social reasons

and safety related to government. There are only 18 industries for which

license is compulsory. With this step, almost 85% of the industry has been
 66

taken out of the licensing framework. The number of industries reserved

for the public sector since 1956 was 17. This number has been reduced to

8. The Government has disinvested a part of the equity of 40 selected

public sector enterprises. Under the MRTP Act, all firms with assets above

Rs.100 Crores were classified as MRTP firms. Such firms were permitted

to enter selected industries only and this also on a case by case approval

basis. The new industrial policy scrapped the threshold limit of assets in

respect of MRTP. The changes with respect to investment and foreign

technology are also designed to attract capital, technology and managerial

expertise from abroad, which, are expected to improve the level of

efficiency of production and raise availability of such scarce resources in

the country.

3.5.4 Exchange Rate Reforms

Apart from various measures of domestic liberalisation, the

strategy for restoring external sector health embraced six key planks.

1. The exchange rate was made market determined.

2. Almost all the economic evils of import license and permit were

gradually phased out. Removal of quota restrictions on imports and

shift towards tariff has been a step in the direction of trade

liberalization. This has been accompanied by substantial decrease in

imports requiring licenses and enlargement of list of imports of OGL.

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3. The heavy anti-export bias was reduced through phased cuts in our

extraordinary high custom tariff.

4. There was a decisive opening up of foreign direct and portfolio

investment.

5. Short-term foreign debts were reduced and strictly controlled,

medium term commercial borrowing was also made subject to

prudential caps and minimum maturities.

6. There was a deliberate policy to build up foreign exchange reserves

to provide more insurance against external stresses and uncertainties.

7. The system of surrendering entire foreign exchange receipts was

liberalised by introduction of partial convertibility of rupees and dual

exchange remittances. Under new system, of all foreign exchange

remittances earned through export of goods or serves or by way of

other remittances, 60% is converted at market exchange rate while

only 40% is converted at official exchange rate.

As a result of introduction of these measures, the following

improvements in foreign exchange were noticeable.

1. Export growth zoomed up to 20% in 1993-94 and two years

thereafter.

2. Inward remittances by NRI quadrupled from 2 Billion in 1990-91 to $

8 Billion in 1996-97.
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3. The current account deficit in the BOP never again exceeded 2% of

GDP and averaged only about 1% for the 10 years after 1990-91.

4. Foreign investment soared from negligible. $ 100 Million in 1990-91

to over $ 6 Billion in 1996-97.

5. Foreign exchange reserves climbed steeply from precarious levels of

1991 to over $ 26 Billion by end of 1996-97.

6. The debt service ratio was halved over a decade.

3.5.5 Financial Reforms

In the financial sphere, deregulation has taken a gradual but

significant turn. Interest rate structure in the money market and banking

system was deregulated and it responded more freely to equate demand

supply imbalances in different segments of financial market. Removal of

ceiling of 10% on the Call Money Market and reduction in SLR

requirements has rendered the call money market a true and fair channeliser

of overnight funds in the banking industry, avoiding artificial shortages.

Control on deposit and lending rates of banks and financial

institutions was also removed with introduction of prime lending rates.

Increase in the deposit rates for lower maturities has been very positive. In

the changed economic perspective, commercial banking in India has

undergone a major transformation in structure, operating policies,

accounting norms and so on. The implementation of recommendation of

 69

Narasimham Committee - I and II and Goiporia Committee were

instrumental in arresting qualitative deterioration of the banking system.

Since 1992-93 prudential norms .relating to (I) income recognition (II) asset

classification and (III) capital adequacy are applicable to the Indian

commercial banks. Important policy initiatives have been taken to improve

the profitability of banks. These are (I) reduction of SLR and CRR, (II)

increase in investment limit in shares/debentures from 1.5 to 5% of the

incremental deposits of banks, (III) permission to banks to directly

undertake leasing, factoring and hire/purchase business (IV) closure of

unprofitable branches (V) merger of banks (VI) greater operational

flexibility to banks to determine the quantum and forms of finance (VII)

deregulation of interest rates.

The abolition of ceiling of 14% on the interest rate on debenture

and term loans by the institutions also made the long term finance costlier.

The quantum of equity issues and its pricing was subject to Government

control through the Controller of Capital Issue (CCI). The pricing equities

which was governed by the CCI formulae has inherent downward bias in

valuation and pricing of new or additional equity. There has been a sharp

spurt in the capital issues. The number of capital issues during the quarter

of April-June 1992 have nearly doubled to 137 from 75 during the same

period of 1991 while the amount raised by the private corporate sector
 70

through these issues has risen more ihan three times to Rs. 1.572 crores

from Rs.509 crores.

The main elements of the framework of the securities market in

India are company law, securities contact regulations, listing of securities

and the Securities Exchange Board of India (SEBI). Many amendments

were brought about in these elements to make the framework flexible. The

SEBI was constituted in April 1988. It was given statutory status in 1992

under the securities and Exchange Board of India Act. Under the over all

administrative control of the Government of India (Ministry of Finance) the

functions of SEBI are (I) to protect the interest of investors in the securities

market (II) to promote the development of the securities market (III) to

regulate the securities market.

In contrast to its underdeveloped character, a sophisticated,

mature and vibrant money market is round the corner in the country.

Keeping with the rhythm of the economic reforms, money market under

went the following changes:

1. The Chakraborty Committee in 1985 suggested that additional

non-bank institutional participants should be brought into the

Call Money Market which has been implemented.

2. In November 1986, 182 days Treasury Bill was introduced whose

characteristic is that there is no specific amount sought to be

 71

raised and hence it is an instrument specifically tailored to meet

the requirements of holders of short-term liquid funds.

3. The Vaghul Group in 1987 recommended the removal of ceiling on

the inter bank Call Money rate and this has been implemented too.

4. The Discount and Finance House of India Ltd. (DFHI) was set up

in March, 1988 to provide a secondary Market for liquidity. It

was allowed entry in to the Call Money Market in July, 1988.

5. The ceiling on Call Money rate was removed for dealings by

DFHI in October, 1988. This has resulted in limited freeing of

the rate from ceiling.

6. The introduction of Inter Bank participation was announced by

RBI in the credit policy of October, 1988.

7. Certificate of Deposit (CD) was introduced in Indian Money

Market in 1989.

8. Commercial Paper (CP) was introduced on 1,1.90 to enable

companies of high rating to raise short term debts.

9. From October, 1990 all participants in the commercial bill

rediscount market have been provided access to the Call Money

Market as lender.
 72

10. From April, 1991, entities with lendable funds of at least Rs. 20

Crores per transaction could seek entry in to the call/notice

money market and commercial bill rediscount market as lenders

only through DFFII.

11. In April 1991, the scheme of Money Market Mutual Fund was

also announced, where banks and their subsidiaries could set up

MMMFs.

12. The stamp duty on bills of exchange drawn by commercial or

cooperative banks up to 90 days has been remitted by the

Government of India.

13. 364 days TBs were introduced in April, 1992.

14. After abolition of the 91 days TBs on tap, an alternative 14 days

TB was introduced in 1996-97.

15. 28 days TB was introduced in 1998. The auction of 14 days and

91 days TBs are held on weekly basis and 182 days and 364 days

TBs on fortnightly basis3.

Thus Indian Money Market, which was in rudimentary stage in

post-Independence and remained underdeveloped in 1960s’ and 1970s’, has

come a long way keeping pace with the changing environment of 1980s’

and 1990s’.

■’ Indian Financial System - M.Y. Khan, Tata McGiaw Hill Publishing Co. Ltd.. 2000. pp.9-16.
 73

3.5.6 Other Related Reforms: Prudential Norm and Asset Classification

(1) Capital Adequacy Norm

In order to improve the financial health of the banking system, the

Reserve Bank of India introduced a risk based capital standard for banks in

1992-93. Indian banks with international presence were advised to achieve

a capital to risk-weighted assets ratio (CRAR) of 8 per cent by March 31,

1994. Foreign banks operating in India were advised to achieve this norm

of 8 per cent by March 31, 1993, and all other banks were advised to

achieve 4 per cent ratio by March 31, 1993 and 8% by March 31, 1996.

Risk Weighted Assets

To compute the value of risk weighted assets, weights are

assigned to every component of tank’s assets. While investment in

government and other risk free assets are assigned a weight of 0, other

investments promises, advances, guarantees etc. are assigned weights

between 0 and 1. Each asset is multiplied by its weight and the results are

added to arrive at the risk weighted assets.

Capital Base of the Banks

There are two tiers of capital:

Tier I Capital

Tier I capital or core capital base consists of the following:

(l)Paid up equity capital

 74

(2) Reserves

(3) Balance in share premium account

(4) Capital reserves representing surplus arising out of sale proceeds of

assets but not created by revaluation of assets.

From the aggregate of these items, the following items if any, are to be

deducted:

(a) accumulated loss

(b)book value of intangible assets

(c) equity investment in subsidiaries.

Tier II capital

It consists of the following:

(1) Cumulative perpetual preference shares

(2) Revaluation reserves (at 45% of book value at present)

(3) General provisions and loss reserves

(4) Undisclosed reserves

(5) Hybrid debt capital instruments

(6) Subordinated term debt

The total of Tier II elements were limited to a maximum of 100

per cent of Tier I elements for complying with the norms.

 75

Capital Support of the Government

The table below No.4.0 shows the Government fund released

between 1993-97 to consolidate the capital base of nationalized banks.

Table No. 4.0

Year Budget Previsions of Funds released

rupees (crores)

1993-94 5700 -

1994-95 5600 5287

1995-96 850 + 150621 1506

1996-97 2408 2408

Source: RBI Bulletin, Relevant Issues

Besides many nationalized banks have raised capital from the

market to strengthen their capital base.

Capital Adequacy Ratio

It indicates strength of a bank

Tota . Capital Fund

The capital Adequacy ratio -x 100
Total Risk Weighted Assets

Tler I Capital + Tier II Capital

-------£------------ , „„
£—x ioo
Total Risk Weighted Assets

In 1996 the international standard was 8%. However, later it was

increased to 9% and subsequently to 10%. Together, with non-performing

assets, they become the indicator cf the health of the bank. Healthy
 76

banking system play positive role in financial market in general and money

market in particular. The presence of strong banks with high capital

adequacy represent a developed money market. Banks with high capital

adequacy and low NPAs have greater capacity for credit creation and

supply of money. Thus strong financial institutions contribute towards a

deep and vibrant money market.

(2) Non-Performing Assets (NPAs)

A non-performing asset has been defined as a credit facility in

respect of which interest remained unpaid for a period of four quarters ending

March 31, 1993, three quarters ending March 31, 1994 and two quarters

ending March 31, 1995 and onwards. Banks have been instructed not to

charge and take to income account interest on all NPAs. Banks are required to

classify their advances into four broad groups a) standard assets, b) sub­

standard assets, c) doubtful assets, and d) loss assets which is a shift away

from earlier system of classifying the advances into eight health codes. Banks

are required to make provision against sub-standard, doubtful and loss assets.

Regarding accounting standards for investments, banks were

asked to bifurcate their investments in approved securities into “permanent”

and “current” investments. Permanent investments are those which banks

intend to hold till maturity while current investments are those which banks

intend to deal in i.e. buy and sell on a day-to-day basis. The ratio of
 77

“permanent” and “current investment” was fixed at 70:30 per cent for the

year 1992-93. Depreciation in respect of permanent investments need not

be provided but for current investments, depreciation should be fully

provided. The ratio of permanent and current investment of banks

continued at 70:30 per cent till 1995. The ratio was reduced to 60:40 as on

March 1996 and further reduced to 50:50 for the year ending March 1997.

It was prescribed to be 40:60 for the year 1997-98.

Banks were asked to provide 100 per cent for loss assets and not

less than 30% of the total provisioning needed in respect of substantial and

doubtful assets and advances with outstanding balance of less than

Rs.25,000.00 for the year ending March, 1993. The balance of 70%

provisioning needed in respect of the above categories of advances not

provided by banks for year ending March 1993 together with the fresh

provisioning in respect of NPA during the year ending March 1994, had to be

made as on that day. Thereafter provisioning became stricter year by year.

Besides banks were advised to make the following additional

disclosures in the “Notes on Account” to the balance sheet for the year

ended March 31, 1997:

a) Percentage of net NPAs to net advances.

b) The amount of provisions made towards NPA, depreciation in the

value of investments and income tax during the year.

 78

Banks were advised to suitably indicate the amount of

subordinated debt raised as Tier-II. Banks were advised to indicate the

gross value of investments in India and outside India, the aggregate of

provisions for depreciation separately on investment in and outside India

and arrive at the net value of investments in and outside India, and the total

of these should be carried to the Balance Sheet.

As discussed above, NPAs constitute a source of dead weight loss to

the commercial banks and thwart downward movement in lending rates. The

ratio of NPAs to advance reflects the quality of a bank’s loan portfolio. The

net NPA of nationalized banks as a percentage of net advances declined from

10.14% in 1995-96 to 10.07% in 1996-97. However, in absolute terms it

increased from Rs.12,9355 crore in 1995-96 to Rs.13,902.7 crore in 1996-97,

NPA stood at staggering amount of Rs.60,500 crore as on 31st March 2000.

Capital adequacy, asset classification, provisioning are reforms

brought out in financial sector for transparency in profit and loss account

and balance sheet. It prevented tanks from window-dressing of their

balance sheet figures. Thus financial reforms brought out the real position

and real health of banks. Capital adequacy and NPAs are related to capital

and advance portfolio. Hence deeper study of these factors of financial

market is outside the scope of the present work. However, there does exist

intrinsic relation of money market with good health of its players.

 CHAPTER-4

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