Introduction:

RBI’s Financial Stability Report: highlights the following –

• Indian banks will continue to be under pressure because of their bad loans.
• Bad loans will continue to increase in the current financial year while capital adequacy will decline.
• It also highlighted that most of the current policy attention focused on first three of four components of a recovery in financial sector health— recognition, resolution, recapitalization and reform.
• Even as the challenges of recognition, resolution and recapitalization continue to dominate the public debate, there is also a need for a debate on the financial structure reforms that India needs in its next round of economic growth.

Background: Indian Financial Structure in post-independence

There have been two different financial structures till now.

1. Financial structure which came up during the era of planned industrialization.
2. Financial structure that came up after the radical economic reforms of 1991.

Financial structure which came up during the era of planned industrialization.

• The then government set up specialist financial institutions—Industrial Finance Corporation of India, Industrial Credit and Investment Corporation of India and Industrial Development Bank of India—to provide funds to new projects at a time when local financial markets were not developed enough to provide long-term finance for new industrial projects.
• These financial institutions focused on project finance while the commercial banks provided working capital.

Financial structure that came up during second era: after the radical economic reforms of 1991.

• Former RBI governor M. Narasimham committee provided a road map for a complete overhaul of the Indian financial system.
• According to Narasimhan committee, a financial system that had evolved within a system of credit planning would be out of sync with a market economy.
• Narasimhan committee pushed India in the direction of universal banking, as the specialist financial institutions either converted themselves into commercial banks or withered into insignificance.

Concern:

• The experience of the past decade clearly shows that commercial banks have struggled to profitably lend to long-term projects. They are now weighed down with soured loans to steel, telecom, power and infrastructure projects.
• Public sector banks were forced to lend to these projects during the previous credit bubble times.
• Commercial banks have been unable to convert their short-term liabilities to long-term assets for a variety of reasons. The limitations of universal banking are evident now.

What next? Is there a need to create new generation of development finance institutions?

• The old financial institutions could lend cheaply because they had access to subsidized capital—either from international agencies or directly from RBI.
• These options are neither possible nor recommended now.
• To blindly transplant the old financial structure into a market economy is not a good idea.

The way ahead:

• What India perhaps needs is a newer generation of financial agencies that can help build national infrastructure without landing in a balance sheet mess.
• The other alternative is deeper bond markets to provide finance to large projects.
• There is a need for a financial structure in which large companies borrow from the bond markets while smaller companies get their funding from commercial banks.
• The Indian bond market has shown some signs of life in recent years, especially after banks went slow on fresh lending because of their balance sheet troubles. The risks of depending on commercial banks to fund large projects are still evident.