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

Content from the Brookings Institution India Center is now archived. After seven years of an impactful partnership, as of September 11, 2020, Brookings India is now the Centre for Social and Economic Progress, an independent public policy institution based in India.

To sustain India’s 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. This report takes stock of these and other components of India’s financial system, identifies areas of improvement, outlines long-term objectives for financial sector development and reforms, and provides policy recommendations to achieve the long-term objectives.

Key Recommendations

1) Expedite broad-ranging banking reforms: The recapitalisation of Public Sector Banks (PSBs) 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.

2) Develop the corporate bond market: Quantitative restrictions on investment in corporate bonds by 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.

3) Enhance liquidity and participation in 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.

4) Promote secondary markets for managing risk: 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.

5) Strengthen institutional framework: This requires effective implementation of the Insolvency and Bankruptcy Code (IBC), creation of a resolution mechanism for failing financial institutions, and consolidation of regulation across closely-connected financial markets. In addition to sustaining momentum on increasing financial inclusion, greater financial literacy and consumer protection are needed.

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