Policy choices in Indian financial markets and how to make them

25 Oct 2022 , 08:40 AM

How does the RBI ago about making important choices in the financial system. Needless to say, the Indian financial system has undergone tremendous changes in the last 30 years since liberalization. At one point, the Indian financial system was all about public sector banks and a handful of development financial institutions. The DFIs, as originally envisaged, hardly exist today. Instead, private banks, NBFCs, Fintechs as well as non-tradition forms of borrowings have become the norm today and these are becoming as large as or even larger than the financial system as we traditionally understand it.

In a recent lecture delivered by the Deputy Governor, Mr. Rajeshwar Rao, has pointed out to some very interesting changes that have taken place in the Indian financial system over the years. Rao has pointed out that many choices in the financial system in India has been driven by pragmatism and the unique position of India rather than by some pure capitalistic or theoretical considerations. Rao talks about 4 very important trade-offs that the RBI has been making consistently to ensure that the financial system serves its purpose.

1)      Should financial intermediation be bank-led or financial market led?

This is a subtle transition that has been happening in the Indian markets on a consistent basis over the last 3 decades. For example, the emergence of NBFCs and Fintechs is all about financial market led intermediation. Relying on ECBs or domestic debt markets is again a sign of market let intermediation. In all these cases, the role of the banks reduces and the financial market plays a more important role in intermediation.

Is it possible for India to transition from a bank-dominated financial system to a non-bank intermediation channel? According to Rao, there is lot of evidence at a theoretical level to underline that as economies develop and evolve, they need neutral markets that can allocate savings and investments better. That has been happening in India, thanks to mutual funds, equity markets, bond markets etc. Just look at some statistics. India has over 10 crore demat accounts and there is more than Rs40 trillion under management in mutual funds. Both are classic examples of disintermediation, where banks don’t play a direct role.

It is not just about mutual funds and demat accounts where investors park their savings. You must also look at disintermediation from the perspective of the borrowers or the corporates that raise funds. For instance, the outstanding bond issuances are almost to the tune of Rs41 trillion, slightly larger than the total mutual funds AUM. This shift is also good for the banks as the corporate bond market diffuses the risk in the market among more players.

Rao has pointed to two very interesting aspects to what we call as disintermediation. For instance, while NBFCs have been disintermediating, much of the NBFC funding has been coming from banks. So indirectly, banks continue to act as intermediaries. Secondly, banks have a role beyond just converting savings into assets. The PSU banks also have the task of inclusive growth, which is why Rao feels that even in the future the banks will be more critical and not less critical. PSU banks still dominate the spread of banking; both in geographical and demographic terms and that is likely to continue in the future too.

2)      Is there a case for private ownership over public ownership?

According to Rao, the two rounds of nationalization of banks in 1969 and again in 1980 were the events that put Indian banks at the centre of the financial system, especially the PSU banks. It was government ownership that had made the banks trustworthy. According to Rao, even today banks are looked up to as safe havens purely because they have the tacit backing of the RBI and the government of India. Pre liberalization, Indian PSU banks accounted for 90% of all financial market assets, although that changed sharply since.

The role private banks in the financial system is evident from their growth. For instance, between 1997 and 2022, the share of private banks in total credit increased from 3% to 36%. This is at a time when total credit basket itself has expanded massively. However, there has also been a macro benefit of the private sector banks in the sense that overall ratio of bank credit to GDP has grown from 26.7% to 52% between 1995 and 2021. Rao pointed out that banking is not so much about ownership as it is about scale, which is what even the Narasimhan Committee had suggested. Bigger banks have better scale for funding large projects and also for managing risk.

3)      Should the banking model by specialized or diversified?

With the emergence of universal banks, that is the billion dollar question. In the US and Europe, large banks like JP Morgan, Citigroup, Bank of America, Deutsche Bank and UBS are true blue universal banks. Their work extends from core banking to investments to wealth management to investment banking. However, as we have seen in 2008 and again in recent episodes of Credit Suisse and Deutsche, this approach has its advantages and also its numerous disadvantages in terms of risk taking and off-balance sheet exposure.

However, Rao underlined that the government and the RBI had already realized the need to make provisions for the big revolution that the internet and mobile phones would bring about in digital banking. The focused license for small finance banks (SFBs) and payment banks (PBs) were efforts in handling more diversified players in the financial system. NBFCs and micro financial institutions only complemented this arrangement of having more specialized players catering to niche markets.

For now, the regulator is still averse to have universal banks to offer the entire gamut of services. However, large banking groups like SBI, ICICI and HDFC offer the full range of options ranging from banking, wealth management, insurance underwriting and investment banking, albeit under distinct arms-length entities.

4)      To go all out on innovation or stick to customer protection?

This is perhaps the most important part of the debate or the choices that the central bank has to make. It is pointless to look at banking without looking at the innovations happening. But these come with downside risks. For instance, Aadhar based banking and peer to peer (P2P) lending make banking simpler and accessible to millions. However, they also come with some inherent risks pertaining to safety, security and data integrity. Digital banking and online onboarding enables geometric growth in the deposit base. However, it also tends to compromise of the rigor of KYC to some extent. The truth obviously lies somewhere in between.

In conclusion, Rao has expressed the view that India’s financial institutions had stood the test of time as they had navigated through difficult choices in the past and continue to do so today. As he put it aptly, “The success of the financial system is about the 3 “A” matrix. It is about affordability and accessibility, but more importantly it is also about appropriateness.