Introduction

The term ‘financial services’ is broadly used for a set of services provided to ensure efficient mobilization and allocation of funds towards the overall growth of an economy. By directing investment funds to their most productive use, an efficient financial services sector can significantly promote growth and income. As a result, the effective provision of these services is a basic prerequisite for a dynamic and modern economy. Across most developing countries, including India, financial services constitute part of the regulatory system that manages inflow and outflow of foreign capital, reduces exchange rate volatility and provides credit to socially desired sectors.

Countries such as the United States, Japan, as well as some members of European Union have, over the years, been vocal demandeurs of liberalization of different financial services, arguing that barriers to entry hinder economic progress and financial stability. They also have well-developed financial service industries that stand to benefit from access to international markets. However, the rapid flow of money out of developing countries in the aftermath of the Latin American crisis in 1980s and the East Asian crisis in 1997, demonstrated that liberalizing financial markets sans proper planning and management of investment is not a recipe of success. In fact, given their immense importance in overall stability of an economy, there is a broad disagreement among various countries about further liberalization of financial services. These disagreements range from both liberalization in additional financial services sector as well deeper liberalization in a particular sector.

Liberalization of financial services at a multilateral level is largely governed by the General Agreement on Trade in Services (GATS) under the World Trade Organization (WTO). By the time official negotiations under the Uruguay Round were over in 1993, negotiations on financial services remained unfinished. These negotiations continued for two more years and an interim agreement was reached in 1995. The negotiations again reopened in April 1997 and a revised set of commitments in financial services by 70 member countries was agreed on December 1997, and annexed to the GATS as the Fifth Protocol. GATS also required WTO Members to restart negotiations on service liberalization after the fifth year of its implementation. The current round of negotiations has therefore started in 2000, with the objective of further liberalization of trade in all services, including financial services. Under these negotiations, India submitted its revised offers in August 2005.

Current Levels of Liberalization and Ongoing Negotiations under WTO

In the Financial Services Annex to the GATS Agreement, India undertook commitments under various sub-sectors within financial services, mostly in Mode 3.¹ In the banking sector, India committed to allow establishment of branch operations of a foreign bank subject to a license limit of 12 per year. However, India retained the option of restricting entry of foreign banks if their market share exceeded 15 per cent. Apart from this, the foreign banks were also allowed to install ATMs at branches and other places. It also allowed licensed foreign bank branches to invest in other financial services up to a certain limit. The foreign banks were required to constitute a Local Advisory Board, the Chairman and Members of which had to compulsorily be Indian nationals. Finally, public sector banks could invest their surplus funds in term deposits only with scheduled commercial banks in India.

Within the insurance sector, India allowed foreign insurers to insure goods in transit to and from India. Foreign re-insurers were also allowed to take reinsurance but only that part of the risk that was left as residual after statutory placements domestically with Indian insurance companies. This part of the reinsurance could be placed with foreign insurers through overseas brokers. These brokers were also allowed to have resident representatives and representative offices to procure reinsurance business from Indian companies. However, these representatives and offices were not allowed to undertake any other activity in India and their expenses were to be entirely met by remittances from abroad.

Though these commitments signaled some improvement over the original commitments made in 1993, they were well short of the existing regime in 1997. Consequently, in the current round of negotiations India’s trading partners made several liberalization requests to India, both under the bilateral request-offer mode as well as under the plurilateral collective requests. In February 2006, India received plurilateral requests for liberalizing trade in financial services from a number of developed and developing countries.² Some of the major demands made in the banking sector included: undertaking full market access and national treatment commitments in Modes 1 and 2 for all sub-sectors, removal of restrictions on preferred form of presence, numerical quotas, monopolies, exclusive service suppliers, use of foreign capital and equity ceilings and investment by public sector utilities in foreign banks. Foreign service providers also expressed the desire for removal of the priority sector lending requirement as well as restrictions on land acquisition by foreigners and ‘discriminatory’ regulations affecting income tax, solvency ratios and borrowing limits.

In the insurance sector, other Members requested India to undertake full market access and national treatment commitments in Mode 1 and 2 for marine, aviation and transport insurance, reinsurance, insurance intermediation and insurance auxiliary services. They have expressed a desire for removal of restrictions on the choice of the form of commercial presence and partner for foreign service providers as well as limitation on equity participation. They asked for greater transparency in the development and application of domestic regulations.

In the current round of talks India has offered to further open up this sector provided other WTO Members make substantive and satisfactory offers in sectors and modes of supply where India has indicated its interests.³ Within the financial services, India has requested developed countries like Australia, Canada, European Communities and United States to liberalize restrictions on market access and national treatment for data processing of financial services under Mode 2. India has also made several country/member specific requests. For e.g. India has requested Australia to allow bank branches to accept retail deposits and remove the requirement of approval of Australian authorities for setting up of bank branches of parent banks where a single shareholder holds 15 per cent or more share. In the case of European Community, India has requested that a bank subsidiary incorporated in any one of the member states be accepted as incorporated within the EC and be authorized to render financial services in entire EC. In United States, the form of commercial presence, i.e. bank branch or bank subsidiary, depends on individual state regulations and India has requested the removal of such restrictions as they restrict provision of financial services.

India’s conditional revised offer for banking services is largely guided by RBI’s Roadmap for Presence for Foreign Banks in India.⁴ The roadmap has divided further liberalization into two phases. During the first phase, between March 2005 and March 2009, foreign banks will be permitted to establish presence by way of setting up a wholly owned banking subsidiary (WOS) or conversion of the existing branches into a WOS. Consistent with the Roadmap, India has offered to allow foreign banks to enter through branch operations or wholly owned subsidiary of a foreign bank. Given that the number of branches permitted each year has been higher than the WTO commitments, India has agreed to offer up to twenty licenses per year, both for new entrants and existing banks. The minimum start-up capital requirement for these WOS would be Rs 3 billion ($ 73 million) and they have to maintain a capital adequacy of 10 per cent. India has also offered to allow WOS of foreign banks to hold surplus funds of public sector utilities as term deposits, subject to guidelines by RBI.

India has also agreed to allow foreign banks to invest in private sector banks through the FDI route subject to foreign equity ceiling of 49 per cent. However, the combined foreign equity (through FDI, FII and NRI routes) is capped more liberally at 74 per cent.

The resource allocation requirements will be applicable to the foreign banks on a non-discriminatory basis. While public and Indian private sector banks have to ensure that 40 per cent of their net bank credit goes to the priority sector, the limit is only 32 per cent for foreign banks. Finally, India has offered to replace the Local Advisory Board requirement with guidelines on the composition of the board of directors.

In the case of insurance, for both life and non-life insurance as well as reinsurance and retrocession, India has offered to allow foreign equity up to 26 per cent. This is in concordance with the existing regime in India, although an amendment to increase the restriction to 49 per cent is under consideration. In the case of auxiliary services like consultancy, actuarial and risk assessment, foreign equity up to 51 per cent has been allowed. Moreover, India has offered to impose no national treatment limitations on foreign players in life and non-life insurance.

Roadmap for Future

The revised offer on financial services signals a substantial improvement on what was committed in the Uruguay Round. Across most sectors India has offered to bind the existing trade and investment regime. However, India has been shy of making pre-commitments in certain areas where further reforms are in India’s own interest. In the insurance sector, increasing the FDI investment limit up to 49 per cent over the next 3 years will allow greater infusion of capital, introduction of new instruments, market expansion and deeper penetration of insurance services. India can also undertake pre-commitments for merger and acquisitions between foreign banks and Indian private sector banks, especially as RBI’s Roadmap envisions foreign banks entering into mergers and acquisitions with Indian private sector banks after 2009, subject to the 74 per cent investment limit.

Another area where pre-commitment would send a positive signal to India’s trading partners would be regarding provision of national treatment to foreign banks involving solvency ratios, income tax, borrowing limits etc. These would again be consistent with what has been outlined in the Roadmap. Such pre-commitments would signal direction of future reforms and give domestic service providers and regulators time to prepare themselves for competition and put in place the required regulatory regime.

Finally, given the move towards greater capital account convertibility and the advent of e-commerce in financial services, it would be advisable for India to undertake some commitments in Mode 1 and 2 across most financial services. This would also strengthen India’s case as it demands that developed countries provide full market access and national treatment commitment in Mode 1 and data processing of financial services under Mode 2.

Reforms to Strengthen the Financial Services Sector

While liberalizing the financial services sector undoubtedly provides greater opportunities for mobilization and efficient allocation of resources, it is extremely important to have a proper regulatory structure in place along with opening up of the economy. Perhaps in no other sector can imprudent regulations cause more damage than the financial sector which enjoys strong linkages with the rest of the economy. Financial sector irregularities were a prime cause of several recent crises, like the Tequila Crisis (1994), Asian Crisis (1997) and Argentine Crisis (2001).

As India opens its doors to a large number of global banks, some of which have assets comparable to India’s GDP, steps must be taken to strengthen the Indian banks to be able to compete with these banks as well as generate greater international presence. These would include further deregulation of interest rates, reduction in pre-emption of banks’ resources through Statutory Liquidity Ratio (SLR) and Cash Reserve Ratio (CRR) among others. With greater international presence there will be overlaps and potential conflicts between home country regulators of foreign service providers and host country regulators. A mechanism needs to be set in place to resolve such conflicts.

India must also meet the deadlines it has imposed on itself to conform to the Basel II norms. Currently, foreign banks operating in India and Indian banks having presence outside India are required to migrate to the standardized approach for credit risk and the basic indicator approach for operational risk under Basel II with effect from 31 March 2008. All other scheduled commercial banks are encouraged to migrate to these approaches under Basel II in alignment with them but in any case not later than 31 March 2009.

Public sector dominance in insurance companies also needs to be lowered to allow greater level playing field between all players. Resources of these companies must be freed so that they can undertake investment in long term infrastructure projects with market determined returns. More capital needs to be encouraged into the sector as current rates of insurance penetration in India are well below the international average.

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¹ WTO (1998) India’s Schedule of Specific Commitment Supplement 4, GATS/SC/42/Suppl.4
² India has received Financial Services Collective Request on behalf of Australia, Canada, European Communities, Ecuador, Hong Kong, Japan, Republic of Korea, Norway, Macau and United States.
³ WTO (2005) India’s Revised Offer TN/S/O/IND/Rev.1
⁴ RBI (2005) Road map for presence of foreign banks in India