Money & Finance

A vision and action plan for financial sector development and reforms in India

  • Blog Post Date29 January, 2018
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In this article, Agarwal and Prasad present a summary of their new Brookings India report, which takes stock of financial sector development in India, identifies areas of improvement, outlines long-term objectives for financial sector development and reforms, and provides policy recommendations to achieve the long-term objectives.

India is one of the fastest-growing major economies in the world. To sustain the high growth rate and spread its benefits more evenly, the financial sector has a crucial role to play in mobilising resources and channelling them to productive uses. While India has well-functioning and deep equity markets, the banking sector is beset with governance issues and rising non-performing assets (NPAs). Corporate bond markets and secondary markets for managing risk remain underdeveloped.

Where things stand

The banking sector: The Indian banking sector is dominated by Public Sector Banks (PSBs), with a market share of roughly 70% of total banking assets. There has been little dynamism in the banking sector. Since 1991, only 15 licences have been issued to universal banks, a relatively modest number for a fast-growing economy in which the banking system remains the primary source of corporate financing. PSBs remain the biggest contributors to the large and rising stock of NPAs, with a share of approximately 90% of the total stock. Rising NPAs have put a strain on the health of PSBs, reflected in their declining profitability ratios which turned negative in 2016 for the first time in a decade. The deteriorating health of PSBs has adversely affected their ability to lend. Most industrial sectors experienced a slowdown in bank credit growth in the last quarter of 2017.

Bond markets: The issuance activity in the corporate bond market has increased by more than 300% between 2007-08 and 2016-17. However, market capitalisation as a ratio to GDP (gross domestic product) remains low. While trading volume in the secondary market has increased considerably over the years, it still remains miniscule compared to the government bond market and equity markets. More than 90% of the bonds are privately placed and there is not enough diversity among issuers and investors. There are quantitative restrictions on institutional investors as well as on Foreign Portfolio Investors (FPIs), which limits the demand for these bonds. Secondary markets for managing risk related to corporate bonds (for example, the market for credit default swaps) are thin, making investors wary of investing in these bonds.

The government bond market is relatively more mature than the corporate bond market. The average maturity of government securities is 10.5 years and less than 30% of the outstanding stock of dated government securities has a residual maturity of less than five years. On the one hand, this implies low rollover risk. On the other hand, this means that the market for short maturities is not very liquid, which prevents the creation of a benchmark yield curve, especially because the majority of the issuances in the corporate bond market are in the short–medium maturity range (up to five years). The other issue with the government securities market is the lack of diversity in the investor base. The combined share of scheduled commercial banks and the RBI (Reserve Bank of India) in total investment in government securities is more than 50%. The RBI still manages the market borrowings of the central and state governments. This creates a potential conflict of interest between the RBI’s objective of inflation targeting and the institution’s role as the manager of public debt.

Other financial markets: Equity markets are the most developed financial markets in India in terms of size as well as liquidity. However, the degree of market concentration is a potential concern. As of December 2016, the top 100 securities accounted for 70% of turnover in the equity cash segment on the National Stock Exchange (NSE). Commodity markets are characterised by high risk and a lack of confidence among market participants. The National Spot Exchange Limited (NSEL) settlement scam in 2013 dented market confidence and frequent government intervention in commodities trading has kept investors away from this market.

Financial inclusion: The degree of financial inclusion has improved significantly as a result of the Pradhan Mantri Jan Dhan Yojana1. However, the use of financial services remains limited. Inequality in access to finance has declined over time but there is room for improvement.

Regulation and supervision: Trading is fragmented. Equities, bonds, and equity derivatives are traded on the NSE and the Bombay Stock Exchange (BSE). Commodity derivatives trading takes place on commodity exchanges. Similarly, supervision is also fragmented. SEBI (Securities and Exchange Board of India) governs the equity market, corporate bond markets, and commodities derivatives market while the RBI supervises the government bond market, money market, and foreign exchange market.

The way forward

The current issues faced by each segment of the Indian financial sector may seem disparate but are in fact interconnected. For instance, illiquidity in the secondary market for government bonds with short maturity hinders the creation of a benchmark yield curve; the absence of a benchmark yield curve then makes the pricing of corporate bonds difficult. This, in turn, contributes to illiquidity of the secondary market in corporate debt. Thin corporate bond markets leave corporates with few avenues to raise debt and they end up turning to the banking sector for finance, thereby exposing the banking sector to concentration and credit risk. In the absence of a robust bankruptcy framework, banks have to bear the burden of losses emanating from failed projects, largely reflected in higher NPA ratios, further inhibiting their capacity to lend. Hence, what is needed is an integrated approach to financial sector reforms that takes into account the nexus between different sectors rather than thinking about reforms in each sector separately.

There is a need to expedite broad-ranging banking reforms. Recapitalisation is essential, but should be done in tandem with governance reforms that make PSBs more accountable and change their incentive structures to promote efficient allocation of credit to the most productive uses. More competition through entry of new banks and greater private ownership of PSBs would increase the overall dynamism of the banking sector.

At the same time, it is important to develop corporate bond markets, which can provide an alternate source of funding to firms. As we argue in our report, quantitative restrictions on institutional investors, such as insurance companies and pension funds, should be relaxed to broaden the investor base. Other steps could include development of secondary markets to hedge investor risk, facilitation of trading in the corporate repo market, rationalisation of stamp duty, and easing of investment limits for foreign institutional investors.

To further develop the government bond market, the government should consider new instruments, such as inflation-indexed and floating-rate bonds, along with higher limits on foreign investor participation. A clear medium-term path for bringing down the Statutory Liquidity Ratio (SLR), a process the RBI has already initiated, would increase depth and liquidity in both corporate and government bond markets, and reduce financial system distortions resulting from bank financing of fiscal deficits.

Technical, institutional, and regulatory constraints that have held back the development of secondary markets for hedging and managing risk should be addressed. Priorities include more hedging instruments for a broader range of commodities, measures allowing broader investor participation in commodity futures markets to improve liquidity, and development of the interest rate futures market.

In addition to the specific reforms we have identified above, the underlying institutional framework needs to be strengthened to support primary and secondary capital markets. This would require effective implementation of the Insolvency and Bankruptcy Code, creation of a resolution mechanism for failing financial institutions, and consolidation of regulation across closely connected markets. In addition to sustaining momentum on increasing financial inclusion, greater financial literacy, and consumer protection are needed.

As India strives to become an important player in international financial markets, it is important that it pursues its unfinished reform agenda aggressively and expeditiously.


  1. Pradhan Mantri Jan Dhan Yojana (PMJDY) is the Indian government’s flagship financial inclusion scheme. It envisages universal access to banking facilities with at least one basic banking account for every household; financial literacy, access to credit insurance and pension facility.

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