India's Financial System: The Challenges of Reform
James A. Hanson, Senior Financial Policy Advisor, the World Bank Sanjay Kathuria, Senior Economist, the World Bank a
The views and interpretations expressed in this paper are those of the authors, and do not necessarily represent the views of and policies of the World Bank, or its Executive Directors, or the countries they represent. The paper draws heavily on James A. Hanson and Sanjay Kathuria, "India's Financial System, Getting Ready for the Twenty-first Century: An Introduction" in J. A. Hanson and S. Kathuria eds. India: A Financial System for the Twenty First Century, New Delhi, Oxford University Press India, 1999..
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India's Financial System: The Challenges of Reform
A. Introduction. India stands on the cusp of the millennium, having largely completed a first phase of financial sector reforms and in need of a second phase to meet some remaining and new challenges. The first phase — liberalization of interest rate and directed credit — began in the early 1990s, hand-in-hand with real sector deregulation. With prices in the real economy reflecting economic costs more closely and with greater reliance on the private sector, it naturally became important to move from a financial system that was largely an arm of public finance carrying out centralized, directed credit allocations to a system where financial institutions played a much greater role in allocating resources based on their evaluation of risk and return. Cross-country evidence suggests that the new
approach should contribute to faster overall development. (See Levine for a review of the importance of the financial sector in development.) Giving financial sector institutions a greater role in credit allocations entails many changes — not just freeing interest rates and credit allocations but giving more attention to legal, regulatory and supervisory issues and to incentives, an area that often has been neglected. The changes involve not only individual institutions and sectors of the

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