The Indian financial system – Shaken, not stirred
An industry expert elaborates on the reforms that will be necessary to elevate India’s position in the new world order.
- India needs banks to be governed and managed in an independent manner, devoid of perceived or real government involvement.
- Insurers and pensions need to be part of the credit markets for the long-nascent corporate bond market to develop.
- Banks and other credit market participants should be permitted to strip the credit risks that they take on, and actively and flexibly manage them.
India’s Prime Minister, Narendra Modi, announced yesterday that there will be structural reforms in the near-term, including in the financial system, to help position India in its rightful place in the new economic order that will emerge in the years after COVID-19. This is music to the ears of diehard fans of the Indian economy.
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The Indian financial system today is in a peculiar spot where borrowers are more reluctant to borrow, and lenders are less willing to lend. While the former is a reflection partly of the economic environment, the latter is worth dwelling on, as every active constituent of the Indian credit market is in disarray.
* Banks, representing over 70 per cent of the Indian credit market, that were just attempting to emerge from years of accumulated non-performing loans (NPLs) in their corporate books are faced with the prospect of more NPLs in the coming months, thanks to COVID-19, possibly now also in the retail segment, whereas the previous set of NPLs was focused on the corporate segment. This will severely inhibit their ability to lend when that is the need today.
* Non-banking finance companies (NBFCs) had grown to be close to 20 per cent of the Indian credit market, by attempting to increase their market share in lending away from banks. They had supported economic growth since 2014 as banks slowed down their credit growth. NBFCs are now faced with a lack of access to leverage to repay their own borrowings. Their emphasis is now on maintaining their solvency. This has reflected in their market capitalisations spiralling down in recent times, with the stock prices of some of the largest NBFCs coming down by over 50 per cent from their recent peaks. This will inhibit their ability to lend to retail consumers; most NBFCs had substantially de-emphasised the corporate segment in the past 12 months, thanks to NPLs flowing down to them in this segment, after the banks, and impacting their ability to access leverage were they to lend to corporates.
* Asset management companies, ie mutual funds (MFs), were attempting to increase their investments in bonds issued by corporates, based primarily on their credit ratings. The idea was to gainfully deploy the buoyant liquidity that was coming their way since the demonetisation action of 2016 by the Modi government. MFs are now taking a U-turn away from the credit markets, driven by episodes of defaults in margin loans and by NBFCs, as well as illiquidity in the corporate bonds they hold that prevent timely settlement of redemption requests from investors in the MF schemes. This is a reflection, amongst other things, also of the lack of liquidity and depth in the Indian corporate bond market, which has remained nascent for years.
* Insurers and pensions, the long savings firms, have never been an active part of the credit markets in India, other than in select very high-grade issuers, thanks to regulations skewing them to be buyers of choice for government bonds.
So, if you sum all of that up, in the age of paper money, where credit growth drives economic growth, the Indian credit markets are frigid. This is, therefore, a critical segment that needs to be addressed, if India were to play its rightful role in the global economy; one where it captures a large part in the supply chains that shift away from China, exports to competitive markets, and delivers high-quality products to the domestic economy. The case for the Indian opportunity today in the global scene, including the need for reforms to capture it, has been made in the pieces titled “India’s Renaissance Moment” and “Indian Manufacturing – The Road Worth Taking”.
What does it take to fix this, and create a large and deep financial system that can meet the demands of a $5-trillion-plus economy that India can become in the next several years? First up, a few clear and specific calls need to be taken, which are structural in nature, to start the process of reforming the sector.
1. Privatise India’s public sector banks: Public sector banks constitute close to 60 per cent of bank lending in India. Being in the public sector, their employees are public servants, who can be subject to investigations by government agencies on commercial actions taken while so employed. Their inability to take decisive action to handle their portfolios and business priorities in a pragmatic manner has been a large contributor to the sector’s state today. India needs banks to be governed and managed in an independent manner, devoid of perceived or real government involvement. Bank management teams should be driven by commercial incentives to risk-take and perform the stated role of banks and be accountable to their stakeholders including regulators. The point is less about whether private sector banks are better governed, but more about the structure of the system, and the need to create an environment where banks can take decisions in a commercial manner to effectively grow the economy.
2. Deregulate India’s savings institutions: Indian insurance and pension firms are subject to regulations that only permit their participation in corporate bonds that are rated AA or better. This can be argued to be driven largely by the government’s desire to find a captive buyer universe for bonds issued by the State, to finance its deficits. Insurers and pensions should be permitted to actively participate in the credit markets, across the spectrum, and significantly enhance their allocations to alternative asset classes such as private equity, private credit, distressed assets, real estate, and infrastructure. The largest pools of long savings in the country need to be part of the credit markets for the long-nascent corporate bond market to develop. The government’s fiscal deficit financing should be addressed in a manner where firstly there should be a plan to bring it down over time, and secondly, multiple market segments including international markets are tapped in a calibrated way. If India is to become the large economy that it desires to be, the government cannot continue to pre-empt local savings as the only real means to finance its balance sheet, as that will continue to stymie the much-required development of the corporate bond market. Local long savings should also aid the growth of well-governed alternative asset classes that will channelise their long-term capital into Indian industry and infrastructure.
3. Simplify the rules governing international investor participation in the Indian credit market: There are rules that define the contours for international investors to participate in the Indian corporate bond markets via the Foreign Portfolio Investors (FPI) route. Then there is a variant named the Voluntary Retention Route (VRR) that provides some flexibility for corporate bond investments, subject to certain conditions. Separately, there is the SARFAESI Act that provides specific domestic market segments with privileges on collateral enforcement. There are also rules for investments in the Indian distress market via Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs), as against directly buying NPLs from banks. And the list of rules and variants go on. If you see this as difficult to understand, you are not alone. It is a set of rules that enhances complexity, increases uncertainty of outcomes, even creates distrust, and severely inhibits liquidity and international investor participation in the Indian credit markets. There needs to be fresh thinking to consolidate and simplify all rules that form part of this maze. International investors will be a mainstay for the growth of the Indian financial markets, considering India’s ambitions and the lack of domestic capital, and the rules here should be liberalised.
4. Introduce risk defeasance mechanisms: India needs an active credit derivatives and securitisation market. Static risk management where risks just sit in one place has been a big issue and will inhibit scale. Banks and other credit market participants should be permitted to strip the credit risks that they take on, and actively and flexibly manage them. This will maximise risk-taking in the system while optimising risk allocation to the right segments. This is an area where being conservative and minimising complexity, which has been the legacy thinking, is not the right approach if the Indian economy is to scale. While there are existing regulations in these areas, they are limited and ineffective, and need a complete overhaul.
5. Initiate counter-cyclical regulations: India’s financial sector regulations tend to be procyclical. Regulations get tighter during down-cycles, and looser during bull markets. That compounds systemic risks in times like the past few years, when the need of the hour is more pragmatic management of the ecosystem, to contain systemic issues. The regulatory architecture needs to encourage risk-taking, while maintaining the stability of the system, by taking a counter-cyclical approach to framing regulations.
The fact that COVID-19 can be translated to an opportunity from a crisis is a situation that very few countries can find themselves in. India is one of them. An ambitious program of reforms that Prime Minister Modi has stated will follow can provide the much-needed structural base to maximise this opportunity, not just for now, but for decades to come. Globally, credit and liquidity have been consistently moving from being driven by retail bank deposits to wholesale and repo markets, which has significantly enhanced scale and liquidity, across cycles. India too needs to move on from its over-reliance on banks. The Indian financial system needs a serious shake, just a stir will not do.
B.V. Krishnan is the former CEO of KKR India Financial Services.