Holistic approach to financial sector is required

The Government did not have anything to do with the recent hike in petrol prices.

Having de-regulated petrol, it was a commercial decision by the oil companies, with the Group of Ministers dealing only with the prices of the other petroleum by-products, the Finance Minister is reported to have said.

Well, one does not know if we can take this at face value. But, if true, one wishes that the Government does not have anything to do with the prices of the other petroleum by-products also.

For, it will be only in a free pricing environment (of all products) that all economic agents – be they consumers or policy makers such as the Government / Reserve Bank of India - will be forced to confront the distinctions between relative price level changes and overall price level changes.

Therefore, in the oil sector, one does wish a far lesser imprint of Government, like in many other industrial sectors.

Is financial sector different?

A small(er) imprint of Government has been well accepted in the financial sector also. Indeed, this has been a core idea behind financial sector reforms.

Some recent developments in the financial sector, though, indicate that while the broad philosophy of “small Government” is appropriate, Government may still have to play a significant coordinating role in developing the domestic financial markets and financial system.

Indeed, recent experience shows that Government has a key role in ensuring that the regulators of banking, capital markets & asset management and insurance – the three main sub-sectors of the overall financial intermediation sector – adopt a holistic approach towards sectoral development.

It has to be well recognised that endeavouring to develop their respective spheres of financial intermediation, each regulator and its policies impinge on the development of the other sub-sectors.

Further, being the pre-eminent and pre-dominant form of financial intermediation in the country, banking – and its regulator – has naturally a dominant influence on how the other forms of intermediation develop.

(Banking here includes both commercial and central banking).

But, it is interesting to note, from public discussions at least, that the mutual dependence of each of the sub-sectors is not well recognised, if at all.

what is the link?

Take the now well documented case of the slowdown in the life insurance sector (specifically private companies) in the past couple of years and particularly, after the new regulations on linked products with effect from September 2010.

After zooming to 40 per cent in 2008-09 from a zero base in 2001, the market share of private companies in fresh business has fallen 10 percentage points in the last two years.

In analysing the slowdown, the new regulations on linked products – from September 2010 - have been identified as a major causative factor. But, is that all behind the slowdown?

It is instructive to note here that the stagnation / fall in private market share commenced from the second half of 2008-09 itself. Growth plateaued in 2008-09, market share fell some 5 points in 2009-10 and a further 5 points in 2010-11.

It is safe to interpret that the initial depression in market share was as a result of heightened stock market volatility from early 2008-09. Deep falls in stock markets in 2008 undermined ULIP investment sentiments adversely. This weakening of sentiments got accentuated (despite the stock market rally in 2009) as the IRDA started amending ULIP regulations which took final form in September 2010.

Investment environment

So, in analysing the slowdown, one has to understand the underlying financial markets environment. It is the financial markets eco-system – comprising products, instruments, procedures and regulations – which drives the investment preference and performance of insurance companies and by extension their overall performance.

Further, when we consider life insurance specifically, one has to note that consumers by and large still do not consider insurance as a risk hedging instrument but mainly as a tax saving / investments instrument.

The underlying financial markets environment – stocks and bonds performance in terms of levels, volatility and returns – in turn, is crucially determined by the policies of the Reserve Bank of India. Policies of the capital markets regulator - covering the more technical and operational details of stocks and exchanges - too have an important influence on stock market performance.

What drove the private companies to focus pre-dominantly on stocks-linked products when they entered the scene post 2001? Was capital requirements for such products being lower relative to conventional life products the only reason? How vigorous, active and attractive was the bond market – the other investment choice for life companies?

Some basic statistical analysis of stock market data show that Indian stocks are arguably among the most volatile globally. Stocks indeed have generated quite inflation-positive returns in India but at a fairly high risk.

For average annual returns of some 15-16 per cent, the risk measure on Indian stocks is as much as 30 per cent plus. This means that in any year, stocks can either fall 20 per cent or rise 45 per cent. More precisely, there is a 1-in-3 chance that the fall or rise is greater. Overall stock market awareness is still low – the buy high / sell low syndrome is therefore well prevalent.

One has to understand that ULIP sales have to be undertaken in the above underlying environment. It will be challenging to say the least.

As for bonds, the Indian yield curve has, for the last 10 years at least, been extremely flat – amply highlighted by the present levels – 90 days at some 7.65 per cent and 10 years at 8.20 per cent. Where is the yield pick-up on long-term investments which can motivate life companies to focus on bonds? And, more importantly, who is responsible for this state of affairs in bonds? Obviously, the central bank of the country has a key responsibility here.

But, in all the discussions about stocks, bonds, interest rates, RBI, linked products regulations etc, have we heard at all about these inter-linkages and how each regulator's policies will impact development of other sector(s)?

It does seem the Government has a key role to play here.

The FSDC, which was the subject of much media space last year, can attempt to bring about that holistic approach to the financial sector. In insurance, IRDA, under the aegis of the FSDC, has to be talking about monetary policy, interest rates, bond markets development and how the RBI is critical in all this.

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. Views are personal.)