A Reserve Bank of India study of 1997 has suggested a statutory ceiling on public debt through an amendment to the Constitution. The ceiling on debt could be fixed as a proportion of GDP or in absolute terms. Such legal provisions are not new and do exist in several countries. Indirect provisions exist, for instance, in New Zealand, where the central bank has the overriding legal power to ensure that the rate of inflation does not exceed the prescribed target. Argentina has a currency board type of an arrangement, whereby, neither the government nor the central bank has any independent powers to create money. A more direct approach whereby a firm constitutional limit is put on the size of the government deficits exist in Germany and Chile.

Provident funds (PF) and the insurance companies are the holders of long term funds in the system. The demographic structure of India’s population is skewed in favour of young people. Consequently, the inflows into the PF are likely to be more than the outflows from the account.

Over 85% of the money with PF and pension funds is invested in special deposit schemes with the government on which interest accrues without any attendant cash flows for the government under normal circumstances. Bulk of the balance funds are invested in government securities on which government is required to pay regular interest. Further, a significant amount of the funds available with insurance companies is also invested in government securities of varying degrees.

The government can, therefore, on some portion of the government securities held by PF and pension funds issue the equivalent of deep discount bonds for a long-term maturity. This then gives the long-term funds to the government and does not require it to disburse interest to the institutions each year although it would accrue the interest due. To that extent this reduces the government borrowings required to finance the disbursals of interest to the PF/insurance companies

In order to enable the government to borrow required funds; a distribution and trading mechanism should be developed for raising government debt from the retail investor, in small denominations. The system currently in place for the equity and financial sector debt distribution could be used to retail government debt, with suitable incentives being offered. Mechanisms should also be put in place for active trading in these instruments, with the NSE providing the backbone infrastructure. However, it would be preferable to dematerialise and use the NSDL. In the long term this would create an appropriately graded interest rate structure based on the perceived safety level of the borrower, with government interest rates setting the benchmark.

In order to enhance the flow of funds from NRIs, dual nationality type schemes should be floated. This would result in higher foreign inflows into the country.

6.3.1 Rapidly develop debt and equity markets

Refer detailed note on capital market

6.3.2 Reduce pre-emption of provident and insurance funds by the Government and reform the institutional framework to enable these long-term funds to fund infrastructure projects.

The government should allow the insurance companies and pension/provident funds to function on commercial principles with a gradual reduction in pre-emption by the government. In addition to the measures detailed earlier, a number of other measures also need to be taken with respect to pension/provident funds which are detailed in the note on debt market.

In case of long gestation Infrastructure projects such as roads and power, the Government should play an active role, due to the inability of the end user to pay for such services. On the other hand, private participation in the areas like ports and telecom, where the end user has the ability to pay should be encouraged through attractive policies.

Refer to the note on capital markets for details

In order to encourage investment in equity markets, the government should encourage participation in the equity markets by disinvesting its holding in attractive public sector units at a discount. This would result in an increase in the equity flows in the system, as profitable investment opportunities would be available to the investor. The loss made on this disinvestment could be recovered by selling a controlling stake in these companies to a strategic investor.

Currently, the FIs have a significant stake in most large companies in India. However, the equity portfolio of FIs is currently not managed on commercial principles primarily on account of these institutions performing a developmental as well as commercial role. In order to provide long term funds, which would be available for investments, the FIs equity portfolio should be managed on commercial principles with scrips being sold to realise profits as also to fund other projects. This would also create greater floating stock in the equity markets. In doing this, care must be taken to see that markets do not go into a decline. Further, this requires greater freedom of actions as well as recognition that some judgements in offloading scrips may sometimes go wrong even if bona fide.

Currently, the laws require that a company that has become sick should be referred to the BIFR, which will formulate a package for its revival. As part of the BIFR rehabilitation package, the lending agencies are normally required to reschedule/waive interest and principal repayments so as to enable revival of the sick unit. This results in the funds of the lending agency being locked up in these assets for long periods of time pending the revival of the company/closure (in the event that the revival package does not succeed.)

Apart from clogging the flow of funds into the system, this puts considerable pressure on the viability of legitimately competitive companies. Companies being rehabilitated by BIFR often stop worrying about paying capital charges in the form of interest to lenders and dividends to shareholders. This often gives rise to a tendency to price their poorer quality products on the basis of variable cost translating into losses even for healthy companies competing with them. Thus, BIFR has been instrumental in making more companies sick.

There is thus a need to abolish BIFR and institute a system of ‘’seize and sell’’ for quick recovery of loans. This will help dramatically improve NPAs in the system. In addition, the Government of India must consider measures analogous to chapter 11 of the American Bankruptcy Act where such undertakings are allowed access to credit under court supervision.

In order to encourage the flow of funds into the equity markets, the government should permit private money management funds. This would make available a pool of resources, which would then be available for investment in both debt and equity, with the tenure of funds and the investments being determined by the risk profile of the investors.

Increasing financial resources for infrastructure will depend, fundamentally, on greater financial viability of the projects. The sectoral regulatory frameworks in infrastructure - tariffs, processes for changing tariffs, service requirements, entry barriers, risks of changes in the framework, etc. - must generate reasonable rates of return in order to interest investors.

Media reports indicate that households in India hold around 13,000 tonnes of gold. However, the bulk of this (about 10,000 tonnes) is in the form jewelry and cannot be tapped. The bullion or liquid gold is estimated to be around 3000 tonnes. India also imports an average of 600 tonnes of gold. The bullion form of gold of 3000 tonnes is currently valued at Rs 1,20,000 crores at the current price of gold at Rs 400 per gram. In order to release this money, the government could issue gold bonds, with the gold deposited by the government being used to shore up the gold reserves of the country and also increase the total foreign exchange reserves of the country. In addition to the above, the funds locked up in real estate could be released through the development of an active mortgage market.

Refer to the detailed note on Mutual fund industry.

In line with the Narasimhan Committee recommendations, doubtful NPAs should be sold to an Asset Reconstruction Company (ARC) at the realisable value. The ARC should recover the NPAs with the powers of the government with the investors in the NPA bonds issued by the ARC being given some tax benefits to the extent the actual realisation falls short of purchase price from banks.

There is an urgent need to make ARC successful to ensure the release of significant funds into the financial system. Lenders/ARC should have powers to seize and sell and replace defaulting management. A provision for ARCs moves ‘not to be challenged in a civil court needs to be made.

Prudential norms for classification of assets as NPAs should be strengthened so that there is no accumulation of NPAs. The regulation should be strengthened so that there is no evergreening of assets. This could be done through measures like requiring banks to ask for repayment of working capital loans so that NPAs can be identified earlier. Moreover, FIs should not be allowed to reschedule loans to prevent default. This coupled with the better disclosure by borrowers would enable financial sector intermediaries to identify NPAs and deal with the same on an on going basis. Provisions by all financial intermediates should be allowed to be tax deducted, in line with the practices prevalent in countries like the United Kingdom. Use of provisioned amount could be strictly stipulated to prevent misuse.

Financial sector intermediaries should stop funding units that are not likely to be viable in future. However, the capital structure of current entities which are NPAs, but inherently viable, should be restructured so as to ensure loan servicing.

In order to ensure the health of the financial system, the capital adequacy norms should be tightened, with banks borrowing from the markets to achieve the same. Recapitalisation of banks by the government should however be discouraged and should only be resorted to as the last alternative.

In addition to the Land development banks and SFCs, the power of sale should also be vested in banks and financial institutions, in view of the unsatisfactory state of the law of mortgage. Alternatively, tribunals should be set up for recovery of dues to banks and financial institutions, with power of attachment before judgement, for appointment of receivers and for ordering preservation of property. The concerned legislation should be amended to facilitate the same. For example the powers of financial sector intermediaries with respect to "seize and sell" should be enhanced in line with Section 29 (1) of the SFCs Act which grants special powers to SFCs to take over the management of a defaulting unit to realise the dues.

Financial sector intermediaries should stop funding defaulting companies/managements with the details of defaulters being disseminated so as to discourage errant companies/managements. This would result in a stoppage of funds to defaulting companies/managements. Systems should be evolved for pooling of information on borrowers as also their track record.

There are a number of proposals for legal reforms in the financial system. These should be expedited.

Mechanisms for recovery of dues from NPAs should be strengthened through measures like expediting the working of the debt recovery tribunals. Currently, cases are decided in two years time. This should be brought down to 3 months. Moreover, the number of such tribunals should be increased as currently one tribunal serves two states. NBFCs should also be able to refer their recovery cases to the debt recovery tribunals. Currently this facility is available only to banks and FIs.

Alternatively, a parallel legal financial court should be set up to expedite foreclosure and asset recovery, with the same being separate and exclusive of the existing judicial system. The decisions of these courts should not be allowed to be challenged by the regular judicial system. The decisions by these courts should be within defined time frames.

The current lending environment, characterised by fears of vigilance, investigations and inquiries, is acting as a major dampener to the credit flow. In order to encourage the banking sector to lend, the scope of external vigilance and investigating agencies with regard to the banking business should be redefined. Greater freedom of action as well as recognition that some lending judgements may go wrong even if bona fide, must be factored in the redefinition of the scope of vigilance and investigation agencies. Moreover external agencies should have the skill and expertise to take into account the commercial environment within which banks operate.

In order to reduce the recurrence of NPAs, there should be lateral recruitment of professionals, performance-related pay scales and training to develop the required skills in credit, treasury and risk management skills. This would improve the overall efficiency of the financial services intermediaries.

This would result in credit allocations being made on sounder principles and hence an improvement in the overall allocation of funds by the financial system and hence better asset quality.

Regulation in the financial system should be based on the type of activity being undertaken as against the current policy of regulating the form of organisation. (for example : the same regulation should apply to all deposit taking entities) as against different norms for NBFCs, banks and Fis.