The informational quality of financial systems

Updated: Jan 19 2002, 05:30am hrs
Following recent instances of institutional failure in the financial sector, there is an urgent realisation that structural changes can no longer be deferred. This is observed both from the central banks recent report on banking trends and the thoughts expressed by its Governor on the need for corporate governance structures in the financial sector. These trends suggest that institutional restructuring may occupy the centre stage of financial sector reforms. This propels the debate of the role and quality of institutions in economic development to the forefront of the reform agenda.

Its an anomaly in the Indian context that reforms in the financial sector have progressed rapidly on aspects like interest rate deregulation, reduction in reserve requirements, barriers to entry, prudential norms and risk-based supervision etc, but little or no progress has been made on the structural-institutional aspects. Sheltering weak institutions while liberalising operational rules of the game is, therefore, making implementation of operational changes difficult and ineffective. For example, the objectives of deregulation and increasing competition through elimination of entry barriers are not completely realised until a broad-based ownership structure of financial institutions is achieved.

Slow progress on these issues can be explained by the fact that its relatively easy to reform operational rules of the game but institutional reform are slow and difficult to deliver. It spans the entire gamut of judiciary, polity and the bureaucracy and aims at reforming incentive structures. Custom, traditions, entrenched interests, ethical codes or simply the manner in which contracts are negotiated and transactions take place, are more difficult to change. It is these structures that need attention in the next phase of financial reforms.

It might be a worthwhile exercise to reappraise the financial system from an institutional perspective to picture as to how does our financial system fare on this count. A recent study done by James Chan Lee and Sanghoon Ahn (ADB Institute, Working Paper 20) gives us an idea about where India stands. Inspired by institutional economics, the underlying idea is that the capacity of the institutional-governance environment to generate a transparent information base is integral to efficient and strong financial sector development. It draws an index of informational quality that evaluates the relative strengths of financial systems.

In terms of aggregate informational quality, India ranks 44th amongst 55 countries. On a scale of 0-10, India is 3 in 1998. As expected, it is substantially below US and UK (9.1 and 9.4 respectively). The surprise is its placement vis-a-vis financial systems of East Asia. The informational quality of our institutions was poorer in comparison to Korea (5.7), Malaysia (5.8) or even Thailand (4.2), being closer to countries like Pakistan (2.7) and Sri Lanka (2.6) or Peoples Republic of China (2.4).

The informational quality index itself is a weighted average of indicators that capture the regulatory environment, structural strength of banks and the functional quality of capital markets - a broad spectrum. The regulatory environment, for instance, is composed of rule of law, efficiency of the judicial system, corruption, enforcement, ownership concentration and creditors and shareholders rights based upon company law. Indias score is 5.4 in this (sub) index. Again, it is closer to the South Asian countries than the East Asian ones.

The structural strength of banks is particularly relevant as it illustrates the catching up efforts that India has to make. Measures of accounting standards, definition and provisioning of non-performing loans and the quality of bank management dominate it. Indias score on this was 1.7 in 1998. Compared to countries like Korea and Malaysia (4.4 and 5.6 respectively), it indicates the relative weakness of our banks. Its score is lower than Pakistan (2.4) and Sri Lanka (2.8) and is at par with China (1.8). The story is ditto for the functional quality of capital markets, which consists of private bond market capitalisation to GDP, turnover of interest rate derivatives and stock market capitalisation to turnover ratio.

There is no doubt that such indicators, being quantification of complex social processes and occasionally nebulous concepts are arbitrary to a degree. Nevertheless, they do embody integrated information under one umbrella and crudely reflect strengths and weakness vis-a-vis internationally accepted thresholds and provide direction for reform in a holistic sense. To elaborate, take the definition of a non-performing loan in India. Though this has recently been brought forward to 180 days from 365 days, it is still a considerable distance behind the internationally accepted definition of 30 days. On ad hoc measures to protect and bail out weak and unviable institutions, blanket coverage through deposit insurance that breeds adverse depositor and lender behaviour or the share of publicly owned banks in total bank assets. All these features are captured by the index, which can thus be interpreted as reflecting a reasonably accurate picture of the structural strength of our banks.

Assessments for financial sector reforms in India have not so far indulged in this kind of appraisal, resulting in gaps between operational rules and effective implementation not being clearly identified and bridged. For instance, few will disagree with the statement: it is easy to claim that a certain rule is in place in India, but that there is really no guarantee that it is being applied. This gap between formal rules (constitution, laws, property rights etc) and informal constraints (sanctions, custom, taboos, traditions and codes of conduct) is what corrupt the institutional environment and disables a system from functioning purposefully. It underlines the role and quality of institutions in development. Economic policy and incentives, therefore, have to be re-designed to overcome these gaps. The emphasis upon institutional reform before we expose these institutions to the harsh environment of globalised financial markets could not, therefore, have come at a better time. Ignoring this and progressing on others will not only render the latter ineffective but may also result in the kind of financial crisis that East Asia experienced.

The author is Professor, ICRIER and on deputation from RBI. The views expressed here are personal and not of the institution to which she belongs.