The Indian economy is an emerging force in global trade, competition and international investment. In the past decade, along with China, it has set the pace for global economic growth – the economic reforms of 1991 have driven India’s annual gross domestic product (GDP) growth to more than 7%. It is predicted that by 2050 the Indian economy will be five times the size of Japan’s, and its per capita income will have risen to 35 times its present level.
In such a rapidly developing economy, the governance of the banking sector is critical for long-term growth. Financial markets are less mature in developing economies, and banks are the key sources of finance for the majority of corporations. Banks are also the main depository for the economy’s savings.
Prior to economic reforms, India’s banking system catered to the needs of a planned economy, with the public sector playing a dominant role. State ownership of banks enabled large government borrowings through the automatic monetisation of the fiscal deficit and large pre-emptions – both through the statutory holding of government securities and the cash reserve ratio. Myriad regulations and restrictions increased the opacity of the governance and functioning of the sector, and significantly affected the viability and profitability of banks.
New financial forces
The reforms freed up Indian industry to private participation, loosened capital restrictions on corporations and introduced market pricing of initial public offerings. They enabled a rapid shift towards an entrepreneurial economy: 78% of India’s GDP is now from the private sector. Today, India has 22 stock exchanges and about 6000 publicly listed companies, with a total market capitalisation of about $550bn.
The reforms thus marked a shift from the government to the market as the dominant force for financial sector growth. This, in turn, presents India’s banking sector with dynamic new challenges. Indian companies are expanding across multiple geographies, and increasingly attract foreign capital. Such cross-border financial flows and operations have created a demand for the convergence of governance practices in the banks with global standards.
The Reserve Bank of India (RBI) and the Indian government have taken steps to enable effective governance processes in the banking sector. For example, the RBI has moved to a model of governance by prudential norms rather than direct interference, and more flexibility has been granted to bank management, both in directing credit and setting prices. There have also been attempts to infuse greater transparency and liquidity in markets for government securities and other asset markets.
There is also a shift towards greater professional representation on bank boards, with an emphasis on boards being elected rather than appointed. Public sector banks have been given greater operational and managerial freedom. This has been accompanied by stronger disclosure norms and an emphasis on independent risk management, compliance and audit processes. Recent provisions, such as the code of conduct and training for directors, are also driving a new sense of direction to decision making and corporate governance in Indian banks.
Still more to do
The reforms are not without caveats. The government must create greater freedom for foreign banks to expand and establish themselves in the country to drive international competition and enable the sector to benchmark itself to global standards in governance and functioning. The state-owned banks control more than three-quarters of the financial assets of India’s banking system. Although 33 foreign banks operate in the India, they account for less than 7% of total assets.
Indian banks must recognise that governance practices must continually evolve in a dynamic global market. The east Asian economic crisis, corporate scandals in the US and Europe, and the Sarbanes-Oxley Act have affected approved governance and disclosure practices. In July 2005, the Basel Committee on Banking Supervision issued a consultative document to enhance governance for banking organisations, and has invited further recommendations.
In such a dynamic environment, Indian banks must realise that corporate governance cannot be directed solely from above by the RBI and central government. Banks’ voluntary adoption of global governance practices is essential for continued growth and to stay relevant in a changing market.
N. R. Narayana Murthy is chairman of the board and chief mentor at Infosys Technologies.
