Promoting market discipline through interest rates: does financial liberalization matter?

Abstract

This article explores whether financial liberalization promotes market discipline in Indian banking in the form of lower deposit interest rates. Using annual data on banks from 1993 to 2004, the findings reveal that, after controlling for a myriad of factors, financial liberalization is influential in promoting market discipline by lowering deposit rates, particularly for state-owned and old private bank groups. More importantly, under financial liberalization, banks that are well-capitalized and have low levels of sticky loans pay lower deposit rates. The policy implication of the analysis is that promoting greater financial liberalization can have important ramifications in promoting market discipline.

Notes

¹ The views expressed and the approach pursued in the article expresses the personal opinion of the author.

² The All-India Debt and Investment Survey observed that out of the total borrowings of farmers in 1951 and 1952, which was estimated at Rs.7500 million, commercial banks provided only 0.9%, while money lenders provided 70% (RBI, 1954).

³ The banking system in India comprises of commercial and co-operative banks, of which the former accounts for around 98% of banking system assets. The commercial banks, in turn, comprise of the 19 nationalized banks (majority holding with the Government) and the State Bank of India (majority holding being with the Reserve Bank of India, the country's central bank) and its seven associate banks (majority holding being with State Bank of India). These 27 banks comprise the state-owned banking system in India and accounted for, on average, over 70% of commercial banking assets during the sample period. In addition, there are the old private banks and the new private banks (established post initiation of reforms in 1991 and 1992) and the foreign banks. The entire segment is referred to as commercial banks. The financial year for banks extends from the first day of April of a particular year to the last day of March of the following year. Accordingly, the year 1990 and 1991 refers to the period April 1990 through March 1991 and so on for other years.

⁴ CRR denotes the impounding of bank deposits by the central bank as reserve requirement and SLR indicates the percent of deposits invested in eligible government securities. On the eve of economic reforms in July 1991, these ratios stood at 25% and 38.5%, respectively.

⁵ This unbalancedness for the year 1995 and the later years arises because out of the eight de novo private banks, seven became operational in 1995 and the remaining one became operative in 1996. The expanded sample comprises of 27 state-owned banks, 15 old private banks, eight de novo private banks and 14 foreign banks.

⁶ CAMEL is the acronym for Capital adequacy, Asset quality, Management, Earnings and Liquidity (see Table 3).

⁷ This variable reflects the individual preference for holding currency relative to bank deposits. If depositors perceive an increase in systemic risks, they might withdraw their deposit from banks, regardless of bank fundamentals. This would entail a lower interest paid on deposits along with an increase in the value of cash outside banks over system deposits. Therefore, a negative correlation between interest rate variable and CASH can be interpreted as evidence of contagion effects.

⁸ Instead of employing CPI directly, we also experimented with a 3-year rolling standard deviation of CPI over the year to capture uncertainty. The results were unaltered with such specification.

⁹ Following Laeven (2003), we also experimented with FLI6 where we considered six aspects of financial liberalization and excluded the external dimension of financial liberalization pertaining to international financial transactions. The results were materially unaltered with such specification.

Additional information

Notes on contributors

Saibal Ghosh1

1 The views expressed and the approach pursued in the article expresses the personal opinion of the author.