India Transformed
Page 53
In retrospect, a calibrated approach to liberalizing capital markets was appropriate in the early 1990s, since it takes time to build regulatory expertise and learn from doing. However, the momentum that was rebuilt in the Vajpayee years was lost in the Manmohan Singh period of 2004–14. Additionally, government did not pay adequate attention to merit plus integrity in appointing board members and heads of SEBI, IRDA and PFRDA.
In the last twenty years, SEBI has been led by administrative-service government officers with little formal training in finance and no market experience. In contrast, government’s choices for RBI governor/deputy governor were usually more appropriate. RBI’s senior management does not need to be as knowledgeable as those leading SEBI about market practices. This is because SEBI’s regulatory oversight is directly associated with transactions. Shortcomings in SEBI leadership have resulted in continued deficiencies in institution-building within SEBI. Indian capital markets would have developed better if the selection of key SEBI personnel, including its chairman, were to be initiated by technical specialists with acknowledged market experience rather than generalists in the finance ministry. Of course, the political executive would necessarily take final appointment decisions.
All things considered, lighter-touch regulation should not be blamed for episodes of malfeasance because it engenders competition and lowers costs. Unfortunately, trading in stocks, debt and derivatives rather than intermediation for investment purposes is the overwhelmingly dominant activity for most globally significant financial-sector firms. SEBI has to be mindful that high trading volumes alone are not necessarily a reliable indicator of well-functioning capital markets.38
Going Forward
A more rigorous process needs to be adopted in the selection of key SEBI personnel and the SEBI Act needs to be amended to include postgraduate-level qualifications in finance/economics plus market experience. Entry-level recruitment should be based on written examinations.
Instances of major wrongdoings in India since 1991—the Harshad Mehta episode in 1992, Ketan Parekh in 2001 and Jignesh Shah in 2013—were followed by regulatory reforms. SEBI needs to continually improve its surveillance capabilities in even closer coordination with the other financial-sector regulators. This includes early-warning systems to spot solvency as distinct from liquidity problems of market makers.
The setting up of a government-sponsored stock exchange to ensure adequate competition, namely NSE, was crucial and NSE has maintained an untarnished reputation. Unfortunately, on 20 September 2016, it was reported39 that SEBI’s Technical Advisory Committee determined that NSE had given unfair access to some brokers for algorithmic (high-frequency) trading. It was reported separately that NSE may be close to listing. NSE is a quasi-regulator and for it to focus on increasing its profits (inevitable as a listed entity) would be inconsistent with the role of stock exchanges to ensure a level playing field across brokers and market participants, including investors.
In the past ten years, every time government–SEBI has sought greater transparency about the beneficiary ownership and details of PNs, FIIs have sold stocks precipitously, and Indian share prices have tumbled. PNs are mostly leveraged positions on Indian stocks. SEBI should seek more details about PN structures and ownership since it is likely that round-tripping is involved.
Markets for exchange-traded interest rate and currency derivatives are functioning well but at lower levels of liquidity compared to developed countries. To an extent, this is due to rupee interest rates, which are not adequately market determined. The government-yield curve would be arbitrage-free if short-selling of government debt securities is allowed. To that extent then, the marking of debt securities to market would be more accurate.
The markets for OTC derivatives, such as interest rate and currency swaps are reasonably liquid but shorter in maturities as compared to corresponding markets in developed countries. If legal remedies for creditors were to be expedited, that would support development of corporate bond markets. Municipal bond markets are stirring and would gain traction as these bodies gain financial and accounting expertise.
An important aspect of effective regulation is responsible assessment of credit risk. S & P and Moody’s are a duopoly in international financial markets and are the majority shareholders of two major Indian credit-rating agencies (CRAs), CRISIL and ICRA.40 CRAs perform a quasi-regulatory function. The government should consider setting up a public-sector CRA. This would increase competition in the ratings space, make CRAs less focused on income maximization and get them to provide better guidelines on how to interpret their credit ratings.
The Institute of Chartered Accountants of India (ICAI) is too close to the accounting profession to be a dependable watchdog. The government should set up a statute-based regulator for accounting.
Appeals against SEBI decisions are heard by the Securities Appellate Tribunal (SAT). Market makers and participants have often complained that SAT takes inordinately long to decide on their appeals. The Ministry of Finance has announced that the SEBI Act will be amended to allow more benches and members in SAT, and this should be followed through.
The high-profile Saradha, so-called ‘chit fund’ scam, and purported instances of fraud involving Subrata Roy relate to allegations that retail investors were cheated through collective investment and other such schemes. In a welcome move, the government has indicated that legislative changes will be introduced within 2016–17 to counter get-rich-quick types of schemes, which are marketed to less knowledgeable and gullible investors.
Inter-regulatory coordination is an important element of the FSDC’s mandate. The jurisdiction of the Ministry of Corporate Affairs overlaps with SEBI (e.g. accounting and registration norms) and with other financial-sector regulators. Hence, the minister for corporate affairs should be a member of the FSDC.
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23
Institution-building in the Financial Sector: The HDFC Experience
Deepak Parekh
Two key lessons emerged for HDFC—first, that trust is the single-most important component in a financial business. Second, that the only product patent a financial institution can have in a competitive market is quality customer service. For HDFC, a value-driven culture of honesty and integrity overrides all other considerations.
Today, it is indeed hard to imagine how primitive the Indian financial system was just a quarter of a century ago. Several economic reforms and liberalization measures were ushered in as a result of the balance-of-payments crisis in 1991. This proved to be a watershed year for India. Some of the key reforms undertaken included the abolition of export subsidies, two-stage depreciation of the Indian rupee, dismantling of the licence raj, reduction in the statutory liquidity and cash reserve ratios of banks, and decontrolling interest rates. However, at that time, few believed that these wide-sweeping reforms would structurally alter the Indian economy.
To better understand the impact of the economic reforms on a financial institution like the Housing Development Finance Corporation Limited (HDFC), it is useful to reflect on the origins of the institution. HDFC was set up in 1977 as India’s first retail housing finance company. At that time, it was akin to a start-up. The only difference was that unlike most start-ups, which are largely set up by young entrepreneurs, this one was a post-retirement venture by the founder, H.T. Parekh. He was sixty-five years old and had retired as the executive chairman of ICICI. The dream to set up a housing finance company in India had germinated in his mind when he was a student studying in the United Kingdom. He had keenly observed that in almost every high street in the UK, there was a building society. Similarly, in the US, there were savings and loan associations. Yet, India remained bereft of any such institution. This thought lingered on in his mind throughout his student days and career, and fructified only two years after he retired. This was the origin of HDFC.
A year after HDFC was set up, I joined the company. I had spent the initial years of my career as an investment banker. Changing tracks after that to join a new start-up company may well have been risky. There were conflicts to deal with. I was giving up a secure job with a foreign bank to join a new company that was still being perceived with a great deal of scepticism. No one in India had so far attempted to finance individuals for their housing needs. Access to long-term finance was difficult and no foreclosure norms existed. At that time, most Indians were extremely debt averse. On the personal front, it meant a drastic reduction in terms of my salary and other benefits. Perhaps it was the excitement and challenge of building a new institution that goaded me to join HDFC. Though our beginnings were small, there was an instant sense of gratification in the work we were doing. One thing was clear to me right from the inception of the company: the need for housing finance was dire and the demand for home loans was immense.
HDFC remained the only housing finance player in India till the late 1980s when insurance companies, public-sector banks and a few private players set up housing finance companies. HDFC also promoted four other housing finance companies. In effect, HDFC created competition for itself!
In 1987, a decade after HDFC came into existence, the National Housing Bank was established as the regulator for housing finance companies, following the recommendations of the Rangarajan Committee.
The housing finance market, though deeply underpenetrated, was beginning to grow as more dedicated players set up companies. Commercial banks, however, preferred to stay away from direct lending of home loans. In fact, commercial banks did not focus on growing their retail portfolios till the late 1990s.
Lessons Learnt from the Financial Crisis
The challenge of growing the housing finance business predominantly concerned raising adequate long-term resources. During the 1980s, HDFC had successfully tapped long-term international funding from the World Bank (guaranteed by the Government of India), International Finance Corporation and the United States Agency for International Development (USAID) under the housing guarantee programme. On the domestic front, funding mainly came from commercial banks, state insurance companies and the Unit Trust of India.
The business of HDFC was a simple one—borrowing wholesale funds and lending them to retail customers at a fixed rate of interest, typically earning a modest spread of around 2 per cent. However, in 1990, the Gulf War came as a rude shock for the Indian economy. Oil prices rose sharply and India’s depleted foreign-currency reserves had left the country on the brink of default. The situation was exacerbated by political instability and unsustainably high fiscal deficits. To curtail rising double-digit inflation rates, the Reserve Bank of India (RBI) raised interest rates sharply. Pre-empting bank credit, the statutory liquidity ratio reached its peak of 38.5 per cent and the cash reserve ratio hovered at 15 per cent.
For a lending institution like HDFC, which was dependent on wholesale funds, the RBI’s actions were stifling. What was worrisome was that the pipeline of home loan approvals was getting stronger but the resource base was shrinking. HDFC also recognized that there was a threshold limit on interest rates beyond which customers would find it difficult to borrow or service the loan. Home loan interest rates had already reached a peak of 18.5 per cent per annum. HDFC knew that it could not afford to renege on its home loan commitments. It just had to find new avenues of raising resources.
At this critical juncture, HDFC realized that it had, over the years, built up a strong brand name, synonymous with quality customer service and trust. HD
FC decided to capitalize on this goodwill by raising retail deposits. While its term deposit rates were marginally higher than the banks’, the key differentiator was the level of service provided. HDFC decided to give the deposit certificate over the counter. This was in contrast to customers having to wait for weeks before getting their deposit receipts. At that time, this convenience was a novelty and helped the company garner substantial resources.
Though retail funding in normal conditions entails a higher cost than wholesale funding, it is a stable form of funding, particularly in periods of disruption. Over the years, HDFC has built a strong network of agents, who today also cross-sell a variety of financial products within the HDFC group.
Little did one expect history to repeat itself so quickly. The contagion effect of the global financial crisis of 2008 resulted in a temporary liquidity freeze in India. Sanctioned bank loans to HDFC were withdrawn overnight as markets faced a crisis of confidence. Once again, for the company, it was the retail deposit franchise that saved the day. Savers trusted the HDFC name and knew that their money would be safe. It was the retail funding component that helped HDFC meet its financial commitments during the period of the liquidity freeze.