Home / Opinion / The declining importance of bank credit

The beginnings of a quiet structural change in Indian finance have been evident for a couple of years now. Companies have begun to seek funds from sources other than banks. These include equity, foreign direct investment, corporate bond issues, commercial paper and borrowing from finance companies. A column in the Mark to Market column in this newspaper reported on 24 March that banks provided barely a fifth of the incremental credit extended to companies in fiscal year 2017.

The immediate reasons for the declining importance of bank credit are not difficult to identify. Banks weighed down with a growing pile of bad loans are in no position to take new risks. Companies have begun to seek other sources of funds. Many of the best companies now look at banks as temporary alternatives when there is urgent liquidity needed. The sharp increase in the issue of corporate bonds is especially noteworthy. It is estimated that around Rs5 trillion of corporate bonds would have been issued in the fiscal year that has just ended.

There are still many lingering problems with the corporate bond market in India. Chief among them is that most of the bonds have been sold through private placements. Investors then hold them till maturity. So, India still does not have a robust secondary market in corporate risk. Yet the sharp rise in primary issuance cannot be wished away.

There are similar challenges in the other new sources of corporate finance as well. For example, most finance companies have been heavily dependent on bank finance for their funds. In other words, the edifice of non-bank finance has been built on bank finance. There are now signs that this is changing, as more finance companies have been able to raise money directly from investors.

There has been a big debate globally about which type of financial system does a better job in allocating national savings—one led by banks or one led by bonds? Neither is a perfect arrangement. If Japan has had banking crises, then so has the US in its bond markets. The underlying truth that the financial cycle moves differently from the business cycle is applicable to both types of financial systems.

India has firmly been in the first category of financial systems dominated by banks. Few can deny the success of Indian banks over the past five decades in mopping up financial savings from every corner of the country, even as they stumbled into bad loan problems almost once every decade because of faulty lending decisions. It is hard to see a point in the near future when banks are completely disintermediated away, as borrowers raise money directly from investors through well-functioning financial markets.

The big policy question is whether India should gradually move away from the dependence on banks. This is the question asked by Jayanth Varma of the Indian Institute of Management (Ahmedabad) in his blog last month.

He has pointed to a few provocative options. First, abolishing the tax deduction on interest as well as lowering the corporate tax rate. This will goad companies to issue more equity. Second, bond markets can be given a fillip by starving the banks of fresh capital. Banks are implicitly subsidized through bailouts. Third, imposing a differential tax on bank borrowing to make other sources of finance relatively more attractive.

Not all enterprises have either the ability or the financial requirements to raise money through bonds. This newspaper has earlier argued that India could move towards a more hybrid financial system where the large companies raise money directly from investors while smaller enterprises continue to go to banks for finance. Even here, banks will face competition. Many finance companies have shown an exemplary ability to assess risks in areas such as truck finance.

The most important concern here is the pivotal role of banks in promoting financial inclusion in a country where too many people still do not have access to formal finance.

The recent surge in bond issuance could be a sign that India—or at least its larger companies—is indeed moving away from its heavy dependence on banks. However, it is only when banks aggressively get back into the lending game that we will know whether the current trend is a temporary response to sluggish lending by the banks or a deeper shift in the Indian financial structure.

Are Indian companies moving towards bond markets for financing needs? Comments are welcome at

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