Liberalisation of Trade in Financial Services and Financial Crisis: A Case Study of India

1. Liberalisation of Trade in Financial Services and Financial Crisis: A Case Study of India IDEAs India

2. 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

3. 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

4. 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

5. 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”.

6. Concerns about Financial Services Trade Negotiations • Domestic regulations are to be based on “objective” and transparent criteria – • Public interest • Basel norms – risk weights

7. 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

8. 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

9. 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.

10. 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)

11. 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)

12. 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

13. 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

14. 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.

15. 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.

16. 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

17. 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

18. 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.

19. 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.

20. 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).

21. 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.

22. 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

23. Country-wise Banking Efficiency and Soundness Indicators after Crisis

24. Banking Performance Indicators for India

25. Bank group-wise Performance Indicators for India

26. Concerns about the Banking Sector

27. Concerns about the Banking Sector

28. 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)

29. Developmental Impact of Banking Liberalisation

30. 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.

31. 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.