In an editorialpublished more than three years ago, this newspaper had warned that the deterioration in the asset quality of banks would be an important challenge for the Indian economy. This was at a time when the first cracks were already evident to those who were prepared to look beyond both the breezy confidence of senior bankers as well as the regulatory forbearance that had been put in place after the global financial crisis. The editorial, published on 2 June 2013, concluded “Indian banks will have to clean up their books before they are ready for the next economic upswing”.
Much has happened since then. Under pressure from the Reserve Bank of India (RBI), public sector banks have begun to admit the extent of their bad loan problem. It is not a pretty picture. A lot of the problem loans are linked to business groups with strong political connections, aka crony capitalists. There has also been a parallel debate about how to strengthen the banks, which includes a range of issues from governance reforms to discounted sales of bad loans to recapitalization by the government.
The Indian banking mess also provides an opportunity to ask some more fundamental questions about the structure of the Indian financial system. RBI has added an important new element to this debate in its new Financial Stability Report, which has a section on the optimal configuration of a financial system, or how much of funding is through banks and how much through the bond market. According to the central bank, “with banks undertaking the much needed balance sheet repairs and a section of the corporate sector coming to terms with deleveraging, the onus of providing credit falls on the other actors”.
India continues to have a financial system that is dominated by banks, making it more similar to the financial system in countries such as Germany rather than the US. There has been a heated debate among economists about whether an optimal financial system should be dominated by banks or the bond market. Without going into this rather technical debate, it is worth reiterating that India needs a more robust bond market.
There are two reasons for this. First, Indian banks are currently in no position to rapidly expand their lending portfolios till they sort out the existing bad loans problem. Second, the heavy demands on bank funds by large companies in effect crowd out small enterprises from funding. India needs to eventually move to a financial system where large companies get most of their funds from the bond markets while banks focus on smaller enterprises.
Of course, this transition is not as easy as it sounds. Indian policy makers have struggled for nearly two decades to get a robust corporate bond market off the ground. Several administrative issues that were identifiedby the committee headed by R.H. Patil in 2005 have since been sorted out. Yet, the Indian corporate bond market continues to be small and shallow.
It is worth pointing out a few structural issues. First, most of the bond market activity has been restricted to small private placements that are held to maturity by passive investors, thus limiting the growth of a secondary market. Second, the sheer size of the annual government programme to fund the fiscal deficit has killed investor appetite for corporate bonds. Third, there are significant obstacles to risk-based pricing of corporate bonds—ranging from the lack of a robust benchmark interest rate to the relative lack of derivative products which investors can use to hedge.
It is highly unlikely that the corporate bond market will ever replace banks as the primary source of funding. Yet, India needs a more lively corporate bond market. It can also play a part in disciplining companies that borrow heavily to fund risky projects, because borrowing costs would spike. Just think: what if Vijay Mallya had to depend on the corporate bond market rather than friendly banks to fund his airline ambitions? An efficient bond market would have poured cold water over these ambitions through higher interest rates unlike the banks which restructured his loans through sweet deals.