A Business Strategy Approach to India’s Financial Sector Reform

With the confidence vote won and the leftists out of the ruling coalition, India’s government has had a chance to resume some of the reforms on its agenda. According to news reports on July 25, the government is now ready to push key financial bills, including opening up the pension sector for private players and raising voting rights of foreign entities in private sector banks, during the current monsoon session of Parliament. Late last year, Finance Minister P Chidambaram had reiterated the government’s intention to “make financial services the next growth engine for India,” including making Mumbai an international financial centre (IFC). That committee, chaired by Percy Mistry, made some sweeping and cogent recommendations. It was followed up by another committee, this time chaired by Raghuram Rajan.

Much of the discussion of these reports tended to focus on the changes required in regulation and macroeconomic policy, and on the overall goals and impacts of financial development. Another aspect of the Mistry committee, or IFC, report, however, deals with what exactly constitutes “financial services”. Unpacking this portmanteau term may be the key to progress in this sector, especially given the difficulties of undertaking sweeping reform. My view is that approaching the financial services sector from a business strategy perspective, identifying niches and potential competitive advantages, will be the best way to promote progress.

The IFC report lists 11 areas of financial services: fund raising, asset management, personal wealth management, transfer pricing, tax management, corporate treasury management, risk management and insurance, exchange trading of financial instruments, financial architecture for large projects, M&As, and financing for public-private partnerships. There is one additional area, which I think offers some potential for India, namely rating services. We can organize these 12 different kinds of services more compactly to understand India’s prospects in various market segments.

First, pure knowledge services are perhaps the easiest for Indian firms to engage in. Providing advice and guidance on the quality of financial assets, on tax matters, and on other issues where market participants require specialized information can be done without too much new institutional infrastructure. The main requirements are access to the appropriate skill and talent pools, and reputation. The reputations of global financial firms operating in India are already established, so it is the Indian firms that will have to find some way to compete effectively. Otherwise, the big rewards will be reaped by foreign brands, not Indian knowledge experts.

Second, exchange trading of financial instruments also represents a large opportunity for India. Electronic exchanges build on Indian expertise in managing IT and IT-based projects, and there is tremendous room for growth in trading a variety of financial instruments. One global trend has been that of packaging idiosyncratic assets into more standardized securities, more easily supporting exchange-based trading. Current policies stifle much of this potential in India, or move it offshore. Exchange-based trading is not only a bread-and-butter opportunity for India’s financial services sector, but it helps develop other segments, since the ability to trade efficiently provides liquidity and encourages the creation of financial assets in the first place. The IFC report offers details on what needs to be done.

Exchange trading of standardized assets is a low-margin but high-volume business. Many financial assets are inherently idiosyncratic, or difficult to price for other reasons. Often, financial firms make their largest profits from deal making in such financial instruments. Again, reputational entry barriers can be high. However, Indian firms can get an advantage if they combine the deal making with specialized knowledge on asset quality, as well as expertise in financial engineering—that is, the creation of new financial assets and contracts. A transparent regulatory regime, free from nitpicking controls and threats of sudden or arbitrary changes in policy, will help turn Indian firms into significant dealmakers.

Financial engineering can be a pure knowledge service, but is much more valuable when combined with the ability to sell the financial products thus created. Personal wealth management, risk management, corporate treasury management, and general asset management can all have a financial engineering component. In fact, innovations here may be the entry point for Indian firms in these areas of financial services. Essentially, where cost advantages are not important, competitive advantage will come from creating more value for clients. Again, streamlining the regulatory regime will be important.

What is being proposed above is a business strategy perspective on the financial services sector, to complement the macro perspective that dominates public discussion. While the IFC report is correct in shying away from “industrial policy” recommendations, it does identify areas where Indian firms may have a potential competitive advantage. These include exchanges for bonds, currencies and derivatives, asset management based on algorithmic trading, and IT-based back-office components of the financial services value chain. The trend towards using IT more heavily—for research, transactions and overall information management—is the driving force for such services.

For success, Indian financial services firms will also need access to more people with the right skills. The IFC report has some excellent recommendations for increasing domestic training in areas such as financial engineering, as well as allowing a greater inflow of human capital from abroad. Relaxing the human capital constraint may be the policy area where the rate of return is the highest. One might also involve some of India’s existing academic talent in areas such as designing new trading institutions: the country has some of the world’s top economists who work on mechanism design and implementation theory, which has emerged from academic obscurity with this year’s Nobel Prize in economics. Many recent financial innovations emerged directly from academia, and this avenue should not be neglected in building India’s financial services sector.