How to Make India Less Dependent On A Broken Banking System

India has created a reasonably well-functioning equity market, but has failed to create a similar banking system.

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. 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 Profit before Interest and Taxes would raise the same revenue as a much higher tax rate applied to Profit before Taxes. 

This would incentivise 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. Forcibly Create A Bond Market

We can try to do this by either:

• starving the banking system of capital, or
• 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 realised that one reason for the lack of a bond market is that the banking system is subsidised by repeated bailouts and ‘too big to fail’ subsidies.

An unsubsidised bond market cannot compete against a subsidised banking system.

The way to level the playing field and enable a vibrant bond market is to neutralise the banking subsidy through an offsetting tax or to limit the subsidy by rationing.

3. Leverage Equity Market To Improve Functioning Of 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 collateralised debt obligations 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. Encourage 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 with large equity capital.

NBFCs find it hard to compete against banks with their ‘too big to fail’ bailout subsidies. 

Neutralising 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.

(JR Varma is a professor at Indian Institute of Management, Ahmedabad (IIMA). This article was first published on his personal blog and published here in an arrangement with BloombergQuint.

The views expressed here are those of the author’s and do not necessarily represent the views of The Quint or its editorial team.)