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Reading: Financial Innovation

Susan Thomas has an excellent presentation on why our financial system is practically archaic; the licence raj still exists there and stifles all innovation. (Source: Ajay Shah)

The license-permit raj in Indian finance

  • No new domestic banks can start operating without RBI

  • All foreign banks put together can start 18 branches a year.
  • Only banks and PDs can become members of the bond exchange.
  • Banks are banned from trading in equity derivatives or commodity derivatives.
  • Currency futures / interest rate futures are not permitted.
  • Wheat (and several other commodity) futures are banned.
  • Credit derivatives are banned.
  • Lending government bonds is banned.
  • Repos on corporate bonds are not permitted.
  • Covered interest parity arbitrage is mostly blocked for banks and impossible for everyone else.
  • Two companies are not permitted to do an OTC derivatives transaction against each other. One counterparty has to be a bank.

We need to free controls and create better markets. What’s the point of a system that refuses to promote liquidity, and transactions? There have been problems worldwide, but that is so in EVERY market – equity, bond, commodities – we haven’t stopped trading them altogether have we? It’s time to learn and implement rules that promote markets but regulate – instead of ditching markets altogether. Will RBI let up?

Nothing will change until after the next elections. RBI isn’t doing much to control inflation, and hopefully is starting to hit the dollar now – it’s dropped from 43.2 to 42.8 in the last five days.

Time for a more liberal market regime, and while the time for it was last year, it’s not too late even now.

  • Anonymous says:

    >Agreed for the most part of it Deepak except for commodity trades. I know what you’d say — Arpan, it’s a free market and at the end of the day a matter of demand and supply. If you want tuar dal prices to be at 1990 levels, increase production etc. All agreed. But the fact of the matter is that as urbanization increases, so does commodity prices for obvious reasons — middlemen, more consumers, less of cultivable land etc. If the prices are regulated, at least for certain commodities, the lesser fortunate are spared. Of course, the counter argument is then why don’t you use ration cards? For one, even if you do not all products would be available at all times (not sure if you ever used a ration card, i have) and for other increasing prices would put a drain on already drained exchequer. Finally, I would have still agreed if the farmer would have benefited. But he’d probably be the last one to gain — the hedge funds and opportunist traders would make all the moolah.

    License raj does make sense in a case like this.


  • Deepak Shenoy says:

    >Arpan: There is little link between trading and market pricing, in general. Have you seen the price increases in NON exchange traded commodities lately? Like tunsten, steel etc? They are 2x the average price increase of the ones traded on teh exchanges!

    The less fortunate are not spared by price limits. In fact, what happens is hoarding and black marketing. That does not help anyone, least of all the government.

    For the farmer to benefit, the APMC act should be radically cut and terminated for the most part, and direct farmer access shoudl be allowed for everything. That is simply liberalisation.

    Remember farmers can benefit much more from trading than without – in fact they do most of the world. it’s only in places like India where they never do the direct trading that they lose the benefits. See ITC’s mandi project – when farmers can trade, they do an amazing job.

    It’s the call to free markets, and there is enough evidence that free and open markets benefit more than unaccessbile ones.

  • Max Dama says:


    I’m wondering about the implications of this:
    “Credit derivatives are banned.”
    So do you have pass-through organizations that originate mortgages and then sell them in bunches to pension funds, investors, etc? Or are all banks simply S&Ls? It must be hard to get a home loan or small business loan if it cannot exceed bank deposits.

    I agree that commodity futures should be allowed to be traded on an exchange. Speculators essentially create liquidity when most people desperately want to sell. Without speculators, supply exceeds demand even more in a panic/selloff and prices plunge more sharply.

    One more question: what exactly is the “raj” and when was it implemented? (a person/law/committee??)

    Max Dama

  • Deepak Shenoy says:

    >Max: ALl banks are S&Ls, but they can internally securitize (can't trade the derivative, and the securitization is OTC) . Additionally there's ARCIL (an asset reconstruction company) that will buy securitized distressed loans.

    Loans have always been tough to come by – that's why banks in India are dramatically increasing capital. Without a credit derivative market, nothing much can be done…liquidity is a concern.

    The "raj" – it literally means "reign". Till 1992, all Indian business was stifled in that you have to have a license to do anything and everything. Licenses dictated how much you could produce, sell, buy etc. So much that regardless of demand you could not bump up production.

    This was dismantled in 1992 (except banking still reeks of it.)

  • Max Dama says:

    >That is very repressive. Sounds like a whole different world than the US. Thanks for the answers.


  • Siddharth says:

    Not-a-communist 😉

    I dont think the farmers were better off in the existence of license raj either.

    Its a double edged sword. Guess what happenend with sugar prices? international market ahd good demand for sugar so to contain the prices in domestic market govt banned export of sugar sometime back, as far as I recall. Correct me if wrong. Now the farmers would have gotten good prices per tonne of the sugarcane they send in the factory but instead the produced sugar was stockpiled and damaged in the weather, consequences of continuing production without downstream movement of the stock.

    So in this sense how does this benefit the farmer by controlling the pricing market? If I was to be farmer I would think this as unfair, why not? I think this is complex subject beyond my understanding but what I get is that meddling in the prices by the govt hurts one and helps one.