Disintermediation: the silent tsunami
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Something remarkable has happened in Indian banking over the last few years. Banks have lost a significant share of new credit to non-banks. For the financial year 2011, the share of bank loans in incremental credit was 72% and that of non-banks (commercial paper, corporate bonds and external commercial borrowing), 28%. By 2017, this has reversed—the banks’ share has plummeted to around 26% and that of non-banks has risen to 74%.
Admittedly, this rise in non-bank lenders has occurred in the context of a general slowdown in credit growth and a deeply impaired banking sector with the non-performing assets overhang. Hence it may be too early to decide if this represents a cyclical or structural shift. It could well be that the trend will be reversed as the banking sector regains health and then its share in credit.
But there are other indicators that provide evidence that at least a part of this shift is structural. The dramatic growth in funds flowing to mutual funds and the growth in assets under management (AUM) of insurance companies suggest that there is a discernible shift in the pattern of financial intermediation in India.
We should welcome the rise of disintermediation. It makes our financial system robust and more efficient in allocating risks. Despite 25 years of liberalization, the Indian financial system is too bank-centric. More than two-thirds of household savings are mobilized through banks. Because of their overwhelming share in providing commercial credit, banks had effectively become receptacles for risks in the economy. Economic challenges in any sector, from aviation to steel, will have an impact on banks. For an economy of the size and complexity of India, such a bank-centric financial system architecture is a constraint on growth. And so, any move away from bank-centricity should be welcome. However, this reconfiguring of the financial sector has profound implications for all the participants in the financial sector. It is important that it takes place in an orderly and non-disruptive manner.
For banks, disintermediation presents a serious challenge. Mutual funds and insurance compete intensely in the highly rated debt segment (rated AA and above) and this is the segment where banks have lost the most share. Banks have a much higher cost of intermediation—between 1.5% and 2%, whereas funds operate at operating costs that are a third of banks’. In addition, regulatory capital requirements mean that banks have to load a capital charge. Higher operating costs combined with this capital charge make them uncompetitive vis-à-vis funds. As disintermediation in this higher-rated segment grows, banks will find their loan-book ratings dropping. Historically, Indian banks have not been very good at pricing credit risk, especially for lower-rated borrowers. Comparison with bond risk premiums reveals that banks have priced their loans as if the average rating was between A and AA, when the actual average rating in India tends to be closer to BBB; banks have charged less risk premium on lending than is needed. A decrease in the overall rating of the loan book will also mean higher regulatory capital. Banks will also be challenged on the deposit side, especially on term deposits which give significantly lower post-tax real returns to investors than debt funds. Thus banks are likely to feel the pressure both on risk-adjusted yields on loans and on cost of funds, thereby diluting margins and lowering return on equity.
Banks could act in a couple of areas. They have to reduce operating costs so that the overall costs of intermediation come down. This is where new digital technologies can play a role. However, most of the current investments under the broad umbrella of “digital” are not oriented towards meaningful cost reduction. Banks can also refocus their lending to segments they have hitherto left to non-banking financial companies (NBFCs)—collateralized lending products such as loans against property and loans against gold, and higher-yield retail lending businesses such as unsecured personal loans and credit cards. Many banks will do so and that will drive down profitability in these segments. This will have an impact on NBFCs that have dominated some of these segments so far.
For disintermediation to turn into a tsunami, mutual funds have to emerge as a “deposit substitute” in addition to being a credit substitute. Around 70% of Indian savings go into banks as deposits which deliver negative or near zero real returns, post-tax. Mutual funds can easily beat deposits on returns. However, there are a couple of features of deposits that make them superior. Regulatory interventions could make these easily go away.
The first issue is that of liquidity. Under normal market conditions, for customers debt funds have nearly the same liquidity as term deposits with banks. However, given illiquid bond markets, they can have serious liquidity problems. The banking system has access to a liquidity window run by the regulator (the liquidity adjustment facility or LAF) that allows it to tide over any short-term liquidity challenge, including, at its extreme, a bank run. Currently, no such strong liquidity support exists for credit funds. There is the collateralized lending and borrowing operation (CBLO) run by Clearing Corporation of India but with rapidly growing credit funds, this window is grossly inadequate. So we should consider providing LAF access to credit funds. This would ensure that in the event of a “fund run” there is enough access to liquidity for funds.
The second issue is about payment features. Bank deposits—especially demand deposits—function as a means for facilitating payments. It’s time we consider giving funds access to payment systems so that they can also provide payment features. Imagine a wallet that rides on a debt fund. It is very common in developed markets for money market funds to have complete access to payment systems—one can even write a cheque on such a fund. In the digital world, it is much easier (and much safer) to provide access to payment systems for funds so that they can add payment features. The funds, on their part, will have to do some product innovation but that is relatively straightforward.
The two steps outlined above could make funds a credible deposit substitute in addition to being a credit substitute. Rebalancing the financial architecture of India evenly between banks and funds will be healthy for the economy—it will distribute credit risk more efficiently, reduce the financial repression of household savers by improving real returns on savings, and will also improve monetary transmission, as funds carry a policy impulse more efficiently than institutions.
Harsh Vardhan is with Bain & Co. These are his personal views.