LIBERALISATION OF TRADE IN FINANCIAL SERVICES AND FINANCIAL CRISIS: A CASE STUDY OF INDIA

IDEAs

India

Coverage of Financial Services under GATS

Broad and “circular” (Gould, 2008) definition of financial services “A financial service is any service of a financial nature offered by a financial service supplier of a Member” and a “financial service supplier” is any individual or corporation in the private sector “wishing to supply or supplying financial services.

Financial services broadly cover Banking Acceptance of deposits Lending Derivatives Securities underwriting Provision of financial information

Insurance Life and non-life insurance Reinsurance

Financial Services Trade Negotiations under GATS

Special status evident from Own negotiating forum within GATS –

negotiations follow Financial Services Agreement

One of the most heavily committed sectors within GATS

Considerable lobbying for developing countries for further market access

Concerns about Financial Services Trade Negotiations

“Understanding on Commitments in Financial Services “ – ambitious provisions Implement stand-still

Automatic permission to new services to be supplied by established firms

Concerns about Financial Services Trade Negotiations

Prudential Carve out under GATS “Notwithstanding any other provisions of the Agreement,

a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders or persons to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system.”

However, less reliable as a means of protection because Disputes about what is protectionist and prudential

across WTO members Countries cannot use prudential regulations as a

means of avoiding their obligations under the GATS

“Where such measures do not conform with the provisions of the Agreement, they shall not be used as a means of avoiding the Member’s commitments or obligations under the Agreement”.

Concerns about Financial Services Trade Negotiations Domestic regulations are to be based on

“objective” and transparent criteria – Public interest Basel norms – risk weights

Financial Services Liberalisation,Capital Flows, Financial Reforms Financial services liberalisation (WTO)

Market access – Allowing entry of foreign producers of services

Liberalisation of capital flows (IMF) Allowing cross border inflows and outflows of

capital Financial “reforms”

Deregulation and privatisation of domestic financial sector Reduced role of public sector in banking Deregulation of interest rates and regulations on

credit allocation

Financial Services Liberalisation and Capital Flows

Liberalisation of financial services and capital account closely associated Repatriation of profits Foreign investments

Sequencing differs from country to country India – Capital account liberalised partially with

restrictions on market access to foreign financial institutions

Domestic financial liberalisation central to liberalisation of capital account and financial services

Financial Liberalisation, Capital Flows and Financial (In)stability

Occurrence of a crisis“In both banking and currency crises, a shock to financial institutions (possibly financial liberalisation and/or increased access to international capital markets) fuels the boom phase of the cycle by providing access to financing. The financial vulnerability of the economy increases as the unbacked liabilities of the banking-system climb to lofty levels”. “Crises may have common origins in the deregulation of the financial system and the boom-bust cycles and asset bubbles that, all too often, accompany financial liberalisation (Kaminsky and Reinhart, 1999).

“Inadequate regulation and lack of supervision at the time of the liberalisation may play a key role in explaining why deregulation and banking crises are so closely entwined” (Caprio and Klingebiel, 1996).

Empirically, in 18 out of 25 cases of banking crisis studied by Kaminsky and Reinhart (1999), financial liberalisation had occurred some time in the previous five years.

Financial Liberalisation, Capital Flows and Financial (In)stability

Occurrence of a crisis

Consolidation of banking sector for better competition with foreign entities – creation of too-big-to-fail institutions (more often, in the private sector)

Financial Liberalisation, Capital Flows and Financial (In)stability

Management of a crisis

Restrictions on nationalisation (of banking sector) or bail outs of public enterprises – Hefty compensations

Inability to step up credit to SMEs – Dominance of foreign banks

Limitation on implementation of stimulus package/social security - Loss of revenue from tariffs (as a major source for LDC governments)

About the Recent Financial Crisis

Global macro-economic imbalances Financial market innovations – growth in

securitised transactions Creation of inadequately appreciated credit

and liquidity risks Excessive deregulation of financial markets

(creation of too-big-to-fail institutions) Pro-cyclical risk measurement, regulation

and accounting Regulatory lapse and arbitrage – shadow

banking

Recent Crisis and Misconceptions about Financial Transactions/Markets

• “Sophisticated maths” helped in countering financial risks (Turner Review, 2009)

• Financial markets were efficient and self-correcting if left to themselves

• Individuals and financial institutions always behaved rationally (herd behaviour, disaster myopia)

• Financial crises generally had roots in developing countries

Major Perspectives from the Crisis

Strengthen counter-cyclical macro-economic policy Prudential regulatory policy (Reforms in BCBS) Fiscal policy

Design structural policies to consonance with their domestic realities (Stiglitz Commission, 2009) – Protectionist versus Prudential

Recognise importance of regulating financial systems (role of governments)

Provide greater attention to productive sectors of the economy in allocation of credit (particularly those affected by the crisis)

Each perspective has implications for future liberalisation of trade in general, and trade in financial services in particular.

Financial Liberalisation after Crisis

 Financial services trade openings can be useful by bringing fresh capital inflows – Pascal Lamy (2008).

However, the experiences with foreign banks operating in developing countries shows that the banks have actually increased the exposure of developing countries to toxic assets. Besides, after the crisis, foreign banks cut down their finances to the domestic sectors adding the shortage of capital.

Trade is a part of the solution to the crisis and WTO can contribute to finding this solution. Conclusion of the Doha round … would give a much needed boost of confidence to economic cooperation - Pascal Lamy (2008).

However, Doha round till now has seen greater push to financial liberalisation from developed world and hence, this would imply a continuation of the thrust on financial liberalisation notwithstanding the crisis.

Financial Liberalisation: A Case Study of India

Features of the Indian financial system

Bank dominated financial system Public sector dominated banking system

(comprising more than 75 per cent of total bank assets)- Bank nationalisation in 1969

Share of banking and insurance services in value added on a sharp increase over last decade Services – 64.5 per cent in 2008-09 from 48.8 in

1990-91 Banking, insurance – 7.1 per cent in 2008-09 from

5.4 per cent in 1993-94

Domestic Banking Sector Liberalisation

Rapid pace of domestic banking liberalisation since 1991 in contrast to the earlier policy of developmental banking Liberalisation in branch licensing policy Liberalisation of interest rates Significant dilution of priority sector lending

norms

Phases of Banking Services Liberalisation under GATS

Banking system opened partially through two phased roadmap since 2005. During the first phase (2005-09)

Foreign banks to operate through branches or set up 100 per cent wholly-owned subsidiaries (WOS).

For new and existing foreign banks, commitment to provide 12 licenses in a year.

Retained the option of restricting entry of foreign banks if their market share exceeded 15 per cent.

M&A of foreign banks only in private sector banks identified for restructuring.

Phases of Banking Services Liberalisation under GATS

During phase II (was to be reviewed in April 2009), it was proposed to To allow WOS to list and dilute their stake

so that at least 26 per cent of the paid up capital of the subsidiary is held by resident Indians at all times. Dilution either by way of Initial Public Offer or as an offer for Sale.

To permit foreign banks to enter into mergers and acquisitions with any private sector bank in India subject to the overall investment limit of 74 per cent.

Stand on Banking Services Liberalisation after Crisis

“In view of the current global financial market turmoil, … it is considered advisable, for the time being, to continue with the current policy and procedures governing the presence of foreign banks in India. The proposed review will be taken up … once there is greater clarity regarding stability, recovery of the global financial system, and a shared understanding on the regulatory and supervisory architecture around the world” (Annual Monetary and Credit Policy, 2009).

Status of Trade in Banking Services

In reality, India has Exceeded limit of 12 licenses a year (15 during

2008-09) 31 foreign banks with 279 branches in 2009

Market share of foreign banks at 47 per cent in 2009 (not invoked restriction of 15 per cent)

Foreign banks lower priority sector lending target (32 per cent)

India’s negotiations aggressively pro-service (including financial) – seen aligning with EU, US at Hong Kong.

Expansion in Indian banks’ operations abroad relatively slow – In 2009, 20 Indian banks with 141 branches abroad – on an average, less than 6 branches a year.

Indian Banking during Crisis

Indian banking withstood the crisis to a large extent due to

Limited direct exposure to crisis ridden assets and institutions

Limited spread of securitised transactions Dominant presence of public sector

During the recent crisis, “public ownership proved out to be a source of strength than weakness for the Indian banking system” (Report on Trend and Progress of Banking in India- 2008-09)

Extensive use of counter-cyclical prudential measures

Country-wise Banking Efficiency and Soundness Indicators after Crisis

(Per cent in Oct 2009)

Country Return on Assets

Gross NPA to Gross

Advances

CRAR Capital to Assets

India 1.0 2.3 13.0 6.4

Brazil 1.1 4.3 18.5 9.2

Mexico 1.2 3.8 15.2 9.1

Russia 0.5 7.6 18.5 13.6

China 1.0 1.8 12.0 5.4

USA 0.2 3.8 13.5 10.1

UK -0.5 1.6 12.9 4.4

Japan 0.2 1.7 13.4 3.6

France 0.4 2.8 10.4 4.2

UAE 2.2 2.5 16.2 10.6

Banking Performance Indicators for India

(Per cent)

Year Return on

Assets

Return on

Equity

Gross NPA ratio

Net NPA ratio

CRAR Credit growth

2006-07 0.9 13.2 2.5 1.0 12.3 30.6

2007-08 1.0 12.5 2.3 1.0 13.0 25.0

2008-09

1.0 13.3 2.3 1.1 13.2 21.2

Bank group-wise Performance Indicators for India

(Per cent)

Number of

banks

Gross NPA to Gross

Advances

Credit growth

Growth in credit to priority sectors

Return on assets

2009 2008 2009 2008

2009

2008

2009 2008 2009

Public sector banks

27 2.7 2.0 24.8 25.7 16.9 17.9 0.8 0.9

Private sector banks

22 2.4 2.8 24.9 10.9 12.9 15.9 1.0 1.0

New private sector banks

7 1.6 3.1 26.3 9.8 - - 1.0 1.0

Old private sector banks

15 3.1 2.4 20.2 15.8 - - 0.9 0.9

Foreign banks

31 1.4 4.0 27.5 2.6 32.9 10.4 1.8 1.6

Concerns about the Banking Sector

Bank group Percentage of off-balance sheet

exposures to total liabilities

2008 2009

Public sector banks 61.3 50.6

New private sector banks 309.8 204.2

Old private sector banks 57.1 50.3

Foreign banks 2804.3 1570.0

All banks 335.1 203.6

Concerns about the Banking Sector

Bank group Lending to Sensitive Sectors (real estate, commodities and capital

markets) as percentage of total advances

2008 2009

Public sector banks 17.5 16.3

New private sector banks

34.5 30.7

Old private sector banks 19.7 19.8

Foreign banks 26.6 30.5

All banks 27.6 11.2

Developmental Impact of Banking Liberalisation

Large number of closure of rural bank branches – 30,524 in 2000 to 28,281 in 2008

Growing shift away of banking from rural to metropolitan areas and from backward to relatively more developed regions

Decline in the access to banking for socio-economically deprived sections (backward tribes and other social groups, and women)

Developmental Impact of Banking Liberalisation

Share in credit Share in deposits

2008 2008 2000 2008

Rural bank branches (28,281 centres)

10.5 7.5 14.6 9.3

Metropolitan bank branches (33 centres)

60.0 68.1 42.6 57.1

Conclusions

Crisis has raised questions about the very process of financial liberalisation.

Further talks during the Doha round on financial services liberalisation need to be kept on hold.

Similar to regulatory reforms being thought of in BCBS, there is need to strengthen prudential regulatory space within GATS.

Conclusions

Developing countries including India need to adopt a conservative approach towards further domestic liberalisation of the financial system.

Developing countries need to lay thrust on supply-driven approach to banking (developmental banking).

Developed and developing countries need to strengthen macro-prudential regulations of financial system and adopt a counter-cyclical approach to prudential regulations.

Developed and developing countries need to expand the scope of regulations to the entire financial system minimising the scope of regulatory arbitrage.