Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Making India less dependent on banks

In the quarter century since economic reforms, India has created a reasonably well functioning equity market, but has failed to create a well functioning banking system. We began the reforms process with a broken banking system, and have come full circle to a broken banking system once again. And no, the mess is not confined to just the public sector banks.

I am reminded of Albert Einstein’s apocryphal remark that insanity consists in doing the same thing over and over again and expecting different results. That leads to the question: what can we do differently. I can think of several things:

  1. We can reduce dependence on debt and rely more on equity. An easy way to do that would be to abolish the tax deduction of interest and reduce the tax rate. A lower tax rate calculated on PBIT (Profit before Interest and Taxes) would raise the same revenue as a much higher tax rate applied to PBT (Profit before Taxes). This would incentivize firms to issue more equity than debt allowing the economy to benefit from the relatively better developed equity market. This would have the added benefit of reducing systemic risk in the economy. The banking system can be downsized by winding up the most inefficient banks. Incidentally, the tax reforms being formulated in the United States today do contemplate abolishing tax deduction for interest expense.

  2. We can try to forcibly create a bond market by either (a) starving the banking system of capital, or (b) imposing a differential tax on bank borrowing. If bank borrowing is rationed or taxed, companies will be forced to borrow from the bond markets. It is not often realized that one reason for the lack of a bond market is that the banking system is subsidized by repeated bailouts and Too Big to Fail (TBTF) subsidies. An unsubsidized bond market cannot compete against a subsidized banking system. The way to level the playing field and enable a vibrant bond market is to neutralize the banking subsidy through an offsetting tax or to limit the subsidy by rationing.

  3. We can leverage the equity market to improve the functioning of the bond market. More than a decade ago, I wrote:

    “Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?”

    For a short time in 2007, when the CDOs had started failing, but the bank failures had not yet begun, I did experience some degree of doubt about this statement. But now I am convinced that banks are simply badly designed CDOs. The global banking regulators seem to agree – much of the post crisis banking reforms (for example, contingent capital, total loss absorbing capital and funeral plans) are simply adapting the best design features of CDOs to banks. The question is why should we make banks more like CDOs when we can simply have real CDOs. In India, the lower tranches of the CDO could trade in our well functioning equity markets, because they offer equity like returns for equity like risks. The senior most tranche would be very much like bank deposits except that they would be backed by much more capital (supporting tranches).

  4. We could encourage the growth of non bank finance companies. Prior to the Global Financial Crisis, GE Capital was perhaps the sixth largest US financial institution by total assets. Even during the crisis, GE Capital perhaps fared better than the banks – it had only a liquidity problem and not a solvency problem. India too could try and create large non deposit taking non bank finance companies (NBFC) with large equity capital. Again NBFCs find it hard to compete against banks with their TBTF bailout subsidies. Neutralizing or rationing these subsidies is one way to let NBFCs grow larger.

I think the time has come to seriously think out of the box to make India less dependent on its non performing banks.

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3 responses to “Making India less dependent on banks

  1. Avinash February 23, 2017 at 5:53 pm

    Till we believe in the doctrine of equity owners being the residual claimaint of the firm and debt owners having a priority over equity owners in cases of bankruptcy, I think it will be unfair to deny interests as a legitimate pretax claim.

    A lot of NPA is associated with adverse selection or poor diligence by banks when project owners have very little skin in the game. Some time back, an example was quoted in newspapers in connection with recent NPAs when all equipments of the project was marked up by 25% through an intermediary of project owner based in Dubai, and as result entire equipment cost got funded on bank money and owner was simply playing on the house money. A well developed bond market would indeed solve this problem to an extent as it will increase the disclosures and also provide a path to taking over the ownership by bond holders if things do not work out.

    I think disincentivizing bank lending without a robust alternative will only lead to lack of credit availability and will be akin to recent notebandi that disincentivized cash over digital paymentrs without a strong digital infrastructure in place.

  2. Pingback: 25 years of economics reforms but banking woes come a full cirlce: Making India less dependent on banks.. | Mostly Economics

  3. Deepti February 28, 2017 at 4:02 pm

    Thanks for the very relevant post, Prof. Varma. Banks in India have far too long enjoyed ‘subsidised’ low cost deposits and accessed recapitalisation funds from Govts in return for furthering the financing of priority sectors and the Govt (through SLR) itself. Bad banks haven’t been shut down and the preferred treatment is to merge them with one of the larger banks that have adequate cushions to absorb the incoming losses. However, the day to day performance of banks in terms of quality of management decision-making on strategies around economic capital, risk-based metrics, and risk management practices have been much less of a prerogative within banking sector policy and regulation but are nevertheless core to having better run banks. I’m sharing a paper we recently worked on, that briefly tries to lay out what some of these ought to be (http://bit.ly/modernisebanking). Hope this is of interest to you.

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