The Paradigm Shift

A RESEARCH PAPER ON REFORMS IN THE FINANCIAL SECTOR IN INDIA

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By: Tarun Kehair (ACA, ACS)

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Background

Financial Sector is the pivot around which any economy hinges. It contributes significantly to the
stability or otherwise in any economy. It paves the way for the right quantum of impetus to drive the
mobilisation and distribution of resources. It is this sector that is responsible for the flow of funds from
the pockets of “surplus” to that of “shortage” and consequently enables Capital Formation in any
economy. Financial sector reforms are one of the most critical components of an economy which has
not only grown in size, but also in strength. There has been a paradigm shift, an evolution in the
thought process from a point in time when they were restricted to just about enabling an increase in
the efficiency of resource mobilization and allocation in the real economy to generate higher rates of
growth, to a point in time where it is so critical for facilitating and sustaining macroeconomic stability
at large. As an obvious repercussion of the East Asian crisis, weaknesses in the financial sector are
broadly regarded as one of the larger contributing causes of collapse in that region.

Banks, Financial Institutions, Instruments and Markets form the crux of the financial sector,
responsible for optimal mobilisation of resources from the “surplus” sector (investments) and
channelizing them to the needy sectors (borrowings) in the economy. It is this process of accumulative
capital growth through institutionalisation of savings and investment; that fosters economic growth.

The Balance of Payments (BoP) records all economic transactions between residents of a country and
the rest of the world and consists of Current account, Capital account, and Financial Account. It is
essentially the difference between inflow of foreign exchange and outflow of foreign exchange. The
1991 Indian economic crisis escalated when India began having severe BoP concerns, as imports
swelled, leaving India also with a Balance of Trade deficit, that is a sure dampener to aggregate
demand. The situation has been said to have become so serious that the Indian foreign exchange
reserves could barely finance three weeks’ worth of imports while the government came close to
defaulting on its financial obligations. By the middle of the year, there was a consequent and sharp
devaluation of the rupee, only to compound the misery. Moody’s and other global credit-rating
agencies further downgraded India from investment grade making it impossible to even get short term
loans; so much so that it is said that even the World Bank and International Monetary Fund inhibited
financial assistance, which fuelled a big step on the part of the Government to mortgage the country's
gold to avoid defaulting on payments.

This crisis also triggered a liberalisation of the Indian economy, as one of the conditions stipulated in
the World Bank loan (structural reform), required India to open itself up to participation from foreign
entities in its industries.

Measures such as incentivising the FDI’s (Foreign Direct Investments), a transformational and
progressive modification of the FDI norms have all been in an endeavour to minimise the BoP gap.

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The reforms in the financial sector have revolved around but not been limited to:

 The FDI Policy and norms;

 The Banking system (including NBFC’s);
 The capital markets (primary and secondary);
 Regulators (RBI, SEBI, IRDA) & the regulatory framework;
 Derivatives (Forwards, Futures);
 Mutual Funds &
 The Insurance sectors

The Reforms that marked an era of evolution

Some of the biggest aspects of reform in the financial sector revolve around Corporate Governance,
increased regulatory supervision and reporting, investor protection and liberalisation, all of which are
so imperative in becoming a global economy.

Some of the reforms that have allowed the Indian Financial Sector Markets to take that big giant leap
are:

o Securities Exchange Board of India (SEBI) that was set up and institutionalised, one
of the major landmarks ever, that kicked off, so to say an era of reformation of the
financial sector. Over the years, if one has closely observed the evolution of this
magnanimous body, there is a clear focus that has emerged stronger over the years,
and that is, the focus and impetus over investor protection, ensuring independence
and objectivity of all positions and bodies that hold a fiduciary relationship with the
Shareholders, and the thought leadership around the fundamental premise of
protecting the rights and interests of the shareholders of any Company. The Issue of
Capital & Disclosure Requirements’ Regulations (ICDR), the Listing Obligations and
Disclosure Requirements (LODR) are evidence of the fact that there is a robust
regulated economy in the making and we have come a long way indeed in ensuring
robust Corporate Governance, all in a bid to ensure the rights and interests of the
Shareholders are protected, in an endeavour to minimise frauds which are
detrimental to their interests and that is one of the biggest milestones vis-à-vis the
reforms the financial sector have been witnessing;

o Establishment of the credit rating agencies, like Credit Rating Information Services of
India Limited (CRISIL). The role of these agencies has always been so critical, in
providing assurance and guidance to the investors around the credit risk. The ratings
so released for existing and prospective corporates and their debt offerings, have
attained the credibility as they are backed by thorough diligence and research. The

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concept of rating a company or its debt offering to enable firms with financials
exhibiting robust debt coverage and sound repayment capacity, to raise funds at
lower costs, and for investors to judge the quality of firms was erstwhile a new
phenomenon but not anymore. There was an imminent need for educating the
Policymakers, including regulators, intermediaries and, most importantly, the issuers
of capital. In keeping with the trend of the early 90’s, other institutions were quick to
follow in the business. IFCI, a financial institution that had also lost ground over the
last couple of decades, imbibed and added this capability, with its chairman, D N
Davar, bringing on board, the former SBI chairman, D N Ghosh, to chair a new agency
— the Investment Information and Credit Rating Agency of India, which came to be
known later as ICRA. Other institutional shareholders came on board, and as the
ratings firm grew, Moody’s too acquired a stake, and later increased its holding. IDBI
also floated another credit ratings agency, CARE and no sooner than later, the Indian
arm of Fitch, another global ratings firm, forayed in to the Indian financial space. There
has been a paradigm shift in the governance of these rating agencies and the larger
objectives with the necessary oversight being provided by SEBI. It is quite an
interesting statistic to observe the coverage of Indian Corporates and Financial
Securities, which has only expanded widely. It is these ratings that the investors
(existing and potential) rely so heavily on, while contemplating investment or
disinvestment in any financial security and this research most certainly paves the way
for informed and studied decisions, which is surely a sign of a “mature financial
market” within a truly “global economy”;

o Another aspect that speaks volume of the reforms the financial sector has witnessed
is the Growth of Mutual Funds. The average Assets Under Management of Indian
Mutual Fund Industry for the month of January 2019 stood at ₹ 24. 52 trillion. The
Indian MF Industry has witnessed a super-natural grown from ₹ 4.78 trillion as on 31st
January, 2009 to ₹23.37 trillion as on 31st January, 2019, which is about 5 times within
a decade; and has grown from ₹9.03 trillion as on 31st January, 2014 to ₹23.37 trillion
as on 31st January, 2019, which is about 2 ½ times; within 5 years. It was the first time
that the assets under management had crossed the milestone of ₹10 Trillion for the
in May 2014 and in a short span of about three years, it doubled and crossed ₹ 20
trillion; this milestone achieved in August 2017. This is 56th consecutive month
witnessing rise in the no. of folios. These statistics are self-explanatory and speak
volumes of the transformational shift in the modus of investing and the available
corpus. The mutual funds bring on the table, expertise and informed diligence and are
a classic option for people who have wealth but little time to manage it and for the
people who have time but little knowledge to grow it. The mutual funds collect funds
from public and other investors and channelize them into the primary and secondary
markets. The first mutual fund to be set up in India was Unit Trust of India in 1964 and
we surely have come a long way.

o India has, over the recent past, also proved to be an effective centre for housing start-
ups. Start-ups, as the name suggests, are new in to business, they may have a

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wonderful concept, and they need the capital to establish and promote the venture.
The idea of “concept selling” has emerged big time over the last decade or a little
more, and that’s when the seed-funds, venture capital funds come in to picture and
they have already fuelled some exciting business concepts and thereby contributed
to a few success stories already. Venture capital represents financial investment in
highly risky projects with a hope of earning high returns. It’s the “exit multiples” that
excite these funds and are an excellent mode of parking funds of the HNWI’s as
alternative investments, and these are then channelized in to exciting business
prospects. The idea and the business flourishes, grows to a decent size, after which
the private equity stakes are pulled back and by then the business is ready to get a
launch-pad in to the Capital Markets vide an IPO. It serves to be a win-win, the Private
Equity Firms earn their revenues by way of management fees and share in profits, the
start-ups get the necessary funding to kick-start their business and the HNWI’s have
an excellent source of multiplying their wealth over time horizons that could stretch
to a maximum of 7-10 years. After 1991, economic liberalisation has made possible to
provide medium- and long-term funds to those firms, which find it difficult to raise
funds from primary markets and by way of loans from FIs and banks.

o Dematerialisation of shares has been introduced in all the shares traded on the
secondary stock markets as well as those issued to the public in the primary markets.
The advantage of demat trade is that it involves Paperless trading and we are now
saved the hassle of filing papers and keeping a manual control as we slowly but
gradually move to a virtual world. The Indian stock exchanges were also modernised
in ‘90s, with Computerised Screen Based Trading System (SBTS), which proves so
effective, given that it cuts down time, cost, risk of error and fraud by reducing manual
intervention. The trading system also provides complete online market information
through various inquiry facilities, which is a great boon for investors and broking
businesses galore.

o Another major hallmark in the imperative goal of investor protection was when the

Central Government notified the establishment of Investor Education and Protection

Fund (IEPF) effective October 2001. The IEPF shall be credited with amounts in unpaid

dividend accounts of companies, application moneys received by companies for

allotment of any securities and due for refund, matured deposits and debentures with

companies and interest accrued there on, if they have remained unclaimed and

unpaid for a period of seven years from the due date of payment. The IEPF will be

utilised for promotion of awareness amongst investors and protection of their

interests. The basic idea and intent being that the investors are more financially

aware, they are able to read and interpret financial statements, understand key terms

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like returns, NAV, costs associated and valuation and are thereby enabled and

empowered enough to make informed decisions, with the only objective of

maximising returns at minimal risks and costs.

o Over the last two decades; post 1999, companies are allowed to buy back of shares.
Through buy back, promoters reduce the floating equity stock in market. Buy back of
shares often serves as one of the anti-takeover strategies, and help companies to
overcome the problem of hostile takeover by rival firms and others. From a
shareholders’ perspective, it serves as one of the modes of distribution of wealth.
Infact, Companies had started effectively using buy-back of shares as a mode of
distribution of wealth to the shareholders, as it is an inexpensive mode of distribution,
vis-à-vis dividend payments. To give an indication around the diverse aspects around
which there have been reforms, erstwhile, there were generally no tax implications
in the hands of company on buyback of its shares under the modes prescribed under
Securities and Exchange Board of India (Buy back of Securities) Regulations, 1998,
since Dividend Distribution Tax (DDT) and buyback tax (BBT) were not triggered. The
buyback of shares listed on a stock exchange could therefore have been considered
as a tax-efficient mode of surplus cash distribution from the company’s standpoint.
In the hands of the shareholders (irrespective of residential status), a buyback triggers
capital gain tax since exemption under Section 10(34A) is available only in cases
where BBT is paid by the company. The buyback of listed shares held for over a year,
qualifies as long-term capital gain (LTCG) and in case the shares are held for a period
less than a year, the gains would qualify as short-term capital gain (STCG).
Consequently, as a measure to minimise misuse of the “buy-back” option and to
ensure that the investors are paid dividends which are tax-free, a domestic company
is now required to pay BBT at the rate of 23.072% (inclusive of surcharge and cess) on
buyback of its unlisted shares implemented under any mode prescribed under the
Companies Act, 1956. BBT is an additional tax in the hands of the domestic company
over and above its income tax liability. In terms of Section 10(34A), a shareholder
participating in such a buyback scheme enjoys tax exemption, irrespective of whether
shares are held as capital assets or stock-in-trade and irrespective of availability of
treaty benefit. Further, no MAT liability is triggered in the hands of a corporate
shareholder. Additionally, U/s 115 O, DDT is levied when the company distributes /
declares / pays dividends to its shareholders. Consequently, the amount of dividend
received by the shareholders is not included in the total income of the shareholder,

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by virtue of exemption provided u/s 10(34), subject to the taxability of dividends u/s
115BBDA. Domestic companies were earlier hence resorting to buy back unlisted
shares instead of payment of dividends, in order to avoid the Dividend Distribution
Tax (DDT) and also to take advantage of the fact that the capital gains arising to the
shareholders are either not chargeable to tax or taxable at a lower rate. Hence, in
order to discourage the companies to resort to such measures, Chapter XII-DA,
comprising of sections 115QA, 115QB, 115QC levies additional income tax on buy
back of such shares by domestic companies. Consequently, per the new provisions,
the income arising to the shareholders by virtue of such buy back of unlisted shares
by the domestic company would be exempt u/s 10(34) and whereas the company
would be liable to pay additional tax on account of such buy back. This is one of the
major changes that have been promulgated as a double-edged sword, one, to ensure
the rights to receive dividends is unimpacted and two, to prevent misuse of the buy-
back option by Companies, again stamping the authority and the intent of the
legislature to protect the rights and interests of the shareholders, which lies at the
heart of the reforms in the financial sector.

o India has also witnessed a mammoth growth in the derivative markets over the years.
SEBI had constituted a committee under the chairmanship of Dr. L. C. Gupta in
November 1996 to “develop appropriate regulatory framework for derivatives
trading in India”, subsequent to which, in March 1998, the L. C. Gupta Committee
(LCGC) submitted its report recommending the introduction of derivatives market in
a phased manner beginning with the introduction of index futures. In addition to the
above, the Derivative Market Review Committee was formed under the governance
of SEBI, under the leadership of Prof M Rammohan Rao to review development of the
derivatives market and suggest future course of action. The committee interalia
recommended to widen the range of products such as option contracts with longer
life or tenure, creation of a volatility index & F&O contacts on it, options of futures,
exchange traded currency contracts and mini contracts on equity indices. The
committee made meaningful observations around operational aspects such as
revision of eligibility criteria for introduction of F&O on stocks & upward revision on
position limits etc. The Committee strongly favours the introduction of financial
derivatives in order to provide the facility for hedging in the most cost-efficient way
against market risk. This is an important economic purpose. At the same time, it
recognizes that in order to make hedging possible, the market should also have
speculators, and not only hedgers and arbitrageurs, who are prepared to be counter-

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parties to hedgers. A derivative market wholly or mostly consisting of speculators is

unlikely to be a sound economic institution. A soundly based derivatives market
requires the presence of both hedgers and speculators. The Committee was of the
opinion that the entry requirements for brokers/dealers for derivatives market have
to be more stringent than for the cash market. These included, not only stringent
capital adequacy requirements but also knowledge requirements in the form of
mandatory passing of a certification programme by the brokers/dealers. One of the
critical regulatory features of derivatives trading is the strict regulation of sales
practices. The objective of SEBI was to make both derivatives market and cash market
fair, efficient and transparent. The Committee identified broker-client relationship
and sales practices for derivatives as needing special regulatory focus. The potential
risk involved in speculating (as opposed to hedging) with derivatives is not understood
widely. In the case of pricing of complex derivatives contracts, there is a real danger
of unethical sales practices. Clients may be fooled or induced to buy unsuitable
derivatives contracts at unfair prices and without properly understanding the risks
involved, and hence the impetus on regulatory focus and awareness programmes.
BSE and NSE were permitted to introduce trading in derivatives on June 09, 2000 with
launch of Equity Index futures followed by Index options. Subsequently, Futures &
Options on Individual stocks were permitted in 2001. Stock Exchanges were provided
flexibility to offer cash settled or physically settled products and were allowed to offer
either European style or American style stock options contracts. Exchanges (BSE &
NSE) have introduced European style option contracts. The possible reasons for
greater trading interest in the options as compared to futures, is, that the Security
Transaction tax (STT) on options is chargeable on option premium value & thus could
be lower in term of value than that of futures where it is chargeable on notional value
and also the trading in options enable market participant’s to deploy various trading
strategies to earn upfront premium that may be used to off-set losses or enhance
gains in their trading position in futures or in cash market. It should be noted that
over the period effective 2004-05 to 2017-18, the Compounded Annual Growth Rate
(CAGR) for the turnover in the cash markets was clearly beaten by that CAGR for the
turnover in the equity derivatives.

o Merchant Banking activities officially started in India way back when Grindlays
started its operations and it’s been growing leaps and bounds thereafter, with
business prospects in this space, only next to none. This activity got it’s real big
kickstart with many primary market offerings in the ‘80’s. Globalisation of the

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economy intertwined with several exciting business prospects like Offshoring,

relaxation of FDI norms to usher foreign entities’ setting up businesses in India in a
bid to get access to scalable talent at a “dream come true” cost arbitrage, provided
impetus to many of the offerings by the Merchant Bankers which required
comprehensive due-diligence. Be it raising funds via equity or debt instruments,
managing the Government consent and permissions for projects, valuation and due-
diligence and providing the necessary strategic advice on Mergers & Acquisitions,
strategic advice on dividend policies commensurate with the level of growth to large
corporate houses, underwriting IPO’s, playing a crucial role in pricing the IPO issues
via book building, advising the use of the “green shoe option” etc., there are so many
opportunities for merchant bankers to come in with the necessary level of expertise.
These are only some of the key offerings that have evolved over time in the Merchant
Banking space, and has shown tremendous success. The very fact that this is
synonymous with validation and decision making substantiated by thorough research
goes such a long way in one of the major reforms that the financial sector has
witnessed.

Exemplary Exhibits

A declining NPA brought about by reforms in the Financial Sector vide Increasing Capital Adequacy Ratio (CAR)

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Market Capitalisation of the Debt & Equity Market Segments: a sign of increasing investor confidence

Conclusion

The Indian Financial Sector has been a victim of frauds that have brought them a lot of disrepute
internationally and there have been scams that have raised many eye-brows. The financial markets
have suffered quite a many blows over the last couple of decades, owing to the manipulative trade
practices of unscrupulous brokers and other participants, which contributed to a lot of need and thrust
for “sound corporate governance” and related regulated regimes. The SEBI, the Ministry of Corporate
Affairs and other critical regulated bodies have done an excellent job in the financial sector witnessing
fine, strong and growing times too over the recent past. India continues its journey towards a
financially inclusive regime through innovative policies involving a multi-pronged approach. India has
come a long way from a financially repressive regime to a modern financial sector where public sector
financial institutions tend to compete with the private sector financial institutions. The Indian
authorities while reforming the financial sector had to constantly keep the issues of equity and
efficiency in mind.

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