Suspense grows over the next leg of financial reforms

Indian banks have indeed traversed a long journey from the time the first European-style bank, Bank of Hindostan, was set up in Calcutta (now Kolkata) in 1771 by managing agents Alexander and Company, followed very quickly by Commercial Bank from managing agents McKintosh and Company. 

These banks may not have stood the test of time, but the broader Indian financial system—including banks—has grown immensely, the long arc of development covering an admirable distance from a rudimentary financing system to the current-day profusion of complex products and services.

This, though, may not be the end of the road, with much left to accomplish still. Finance minister Nirmala Sitharaman’s budget speech provided some clues: “For meeting financing needs of the economy, our government will bring out a financial sector vision and strategy document to prepare the sector in terms of size, capacity and skills. This will set the agenda for the next 5 years and guide the work of the government, regulators, financial institutions and market participants.” 

It is worth asking what kind of “vision and strategy”—or even reforms—are required for the Indian financial sector after undergoing over three decades of reforms since the onset of economic liberalization in 1992. Two areas stand out.

One is the state of the corporate bond market. If the economy has to catalyse private sector investments into productive assets, to enable a step-change in employment generation and economic growth, a robust and deep corporate bond market is non-negotiable. 

The Indian private sector today depends on the banking sector for bulk of its funding, which spawns its own share of aberrations and indiscretions. 

The seeds of misconduct (and future non-performing assets) are sown when banks ask Indian companies to provide equity, a prerequisite for availing a bank loan, leading to padding of project costs and diversion of loan funds. 

This can be obviated somewhat with a deep corporate bond market, comprising heterogenous players with divergent objectives and investment horizons. 

The corporate bond market today can support only top-rated issuers, thereby excluding a bulk of Indian companies, including infrastructure companies, which typically do not enjoy top rating during a project’s early stages. 

Consequently, even with ₹47.3 trillion of bonds outstanding as of March 2024, the corporate bond market enjoys less than 20% share of the wider bond market. With government issuances continuing to dominate, a tentative corporate bond market directly impacts private sector’s propensity for investment.

In addition, skews within the corporate bond market, with finance and non-manufacturing companies accounting for a bulk of issuances, complicate matters. 

And though the government and regulators have been chipping away at the existing legal and regulatory framework to impart more dynamism to the market, there remain some significant unresolved issues. 

For example, poor recovery rates and prolonged recovery processes in cases of defaults are a clear impediment. The problem of unreliable credit ratings, the lack of updated borrower information or conflicts of interest inherent in the “issuer pays” model continue to linger.

As rules and regulation tighten at a glacial pace, borrowers and credit dispensers are finding new ways to get around the guard-rails. This shines a light on what could be the second pillar for reforms in the financial sector: wide open spaces for regulatory arbitrage.

While market operators have always tried to wring surplus profits by exploiting regulatory gaps—the past example of unit-linked insurance products is instructive—recent attempts to use credit products to leverage the cracks between different regulatory agencies pose serious risks to the broader financial system. 

Reserve Bank of India (RBI) governor Shaktikanta Das recently drew attention to the phenomenon of private credit markets: “While these markets may carry economic benefits by providing a greater pool of financing outside of the regulated financial markets and institutions, and their risks appear contained at present, it is important to bear in mind that vulnerabilities and interconnectedness in these markets can amplify negative shocks and pose financial stability concerns.” 

Currently, Sebi-regulated private equity funds and mutual funds have launched credit vehicles that skirt RBI regulation on prudential norms regarding capital adequacy or asset classification and provisioning, thereby endangering financial stability.

But here is the thing. As long as there are regulatory gaps, arbitrageurs will always look to leverage them. The finance ministry, learning from the experience of the 2008 financial crisis, had set up the Financial Stability and Development Council (FSDC) in 2010 to formalise inter-regulator coordination. 

However, very little is known about what transpires at the council’s proceedings, or the stand taken by individual regulators on particular issues. As long as an opaque blanket shrouds the council’s meetings, people will be encouraged to exploit the system. 

The financial sector requires many other reform measures; the finance ministry’s document will hopefully provide some clues about the future direction of reforms.