An Overview of the Complex Indian Financial System

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India’s financial sector has expanded in tandem with the nation’s impressive growth performance. The growth of NBFCs (Non-Banking Financial Companies), increased reliance on market-based financing, and the emergence of digital money and finance are a few examples of how India’s financial system has altered in structure concurrently. 

Public Sector Banks in particular continue to dominate India’s financial system. 60% of all bank assets were held by 12 public sector banks. 46 international banks with operations in India and 22 domestic private sector banks make up the remaining 40%. Additionally, there were about 100,000 regional rural, urban, and rural cooperative banks, illustrating the nation’s regional variety.

Less regulated NBFCs expanded quickly after the asset quality review and tightening of banking regulation in 2015 to address concerns following years of high bank loan expansion. Due to this, NBFC credit growth in 2018 increased by nearly 30%, partially bridging the gap left by slower bank credit growth. Micro, Small, and Medium-Sized Enterprises (MSMEs) gained the most from NBFC loans.

The Turnaround, and The Role of Market-Based Financing

Nonetheless, in 2018, Infrastructure Leasing and Financial Services, a systemically significant NBFC, had a default, which was a significant shock to the industry and had negative knock-on effects for the rest of the financial system as well as the actual economy. Since then, oversight and regulation have been more stringent, and the new scale-based regulatory framework has brought NBFC regulation closer to bank regulation, particularly for the 25–30 largest institutions.

The regulation of smaller NBFCs continues to be less onerous due to their non-systemic status and accompanying regulatory burden. The NBFC business is still intimately linked to the banking industry, which also serves as a significant source of funding for it. Tighter capital, provisioning, and significant exposure requirements for the biggest NBFCs are the main focus of the ongoing regulatory reform agenda for NBFCs.

In India’s financial system, market-based lending is likewise taking on more significance. The bond market expanded quickly over the preceding ten years from a low base, and towards the end of 2021, the total outstanding debt was almost 80% of GDP. Given the potential inclusion of India’s bonds in international bond indices like the Bloomberg, FTSE, and JPMorgan Chase & Co. bond indices, which according to some estimates could result in a passive inflow of $30-$40 billion, the appeal of the country’s bond market to foreign investors has also increased. Although China only holds 2% of the world’s bonds, as indicated by its participation in global bond indices a few years ago, that percentage might climb significantly.

However, there is still a lot of space for growth in the corporate debt market, which now accounts for around 18% of GDP. India’s equities market capitalisation has also increased dramatically, albeit with some swings, and has just passed the US and Canada to rank fifth globally in terms of market capitalization in March 2022, behind China, Japan, Hong Kong SAR, China, and China. 

The Parameters for Assessment, and the road ahead

Yet, indicators of financial sector development including the value of outstanding bonds, equity market capitalization, and bank loan-to-GDP ratios do not accurately reflect India’s financial sector development. For instance, initiatives to promote financial inclusion, such as building the infrastructure for digital payments, have considerably aided the growth of India’s financial sector. India has created a highly effective infrastructure for digital payments.

Unified Payments Interface, an interoperable payments platform, has encouraged innovation and drawn the private sector with new technology and products to various demographic segments, hence improving financial inclusion. Additionally, the payment system is part of a larger digital platform (called the “India Stack“) that includes components including digital identification, data, and payments.

Financial inclusion will be strengthened through ongoing efforts, such as developments that permit the use of low-tech cell phones to conduct financial transactions. With substantial synergies between the public and commercial sectors, progress has been made in a comparatively short amount of time. By March 2023, the Reserve Bank of India (RBI) expects to start the gradual adoption of a Central Bank Digital Currency (CBDC), which has the potential to improve the current state of digital payments. Over a hundred other nations are investigating or testing CBDCs in some capacity.

While CBDCs provide advantages, they may also present concerns, such as risks to financial stability, hence it is crucial to manage these risks through proper CBDC design as well as within the confines of the legal and regulatory frameworks.

The government announced tougher governance measures in 2019, allowing banks to hire chief risk officers from the market, increasing the role of externally appointed board directors, making management more accountable to boards of directors, and increasing flexibility in adjusting management compensation.

Detailed restructuring plans were once again introduced during COVID-19 to deal with nonperforming loans more effectively, and the authorities established National Assets Reconstruction Company Limited (NARCL) to handle distressed assets. Banks in the public and private sectors both raised more capital. The banking sector reform agenda is still extensive despite these steps.

Similar to other nations, India’s financial sector is facing new difficulties, such as the effects of climate change and the need for adaptation. As a result, there are several opportunities to build on the progress made in enhancing access to financial services for populations who are economically disadvantaged. However, financial innovations and the quick development of the financial sector also provide ongoing problems for financial sector legislation and supervision, which must be revised regularly to allow for the healthy development of the financial sector while preventing risk accumulation.