A budgetary signal as banks cannot bear it all

UPSC Syllabus: Gs Paper 3- Indian economy

Introduction

Budget 2026 signals a limited but important shift in India’s financial-sector reform approach. It reflects recognition that Indian banks are carrying risks that well-functioning markets usually absorb. Because corporate credit markets remain shallow, banks have become the main providers of long-term finance. This structural imbalance has steadily increased pressure on bank balance sheets and made the financial system more vulnerable. The proposed measures aim to redistribute risk through markets rather than concentrating it within banks.

Major Issue with India’s Financial Architecture

1. Structural imbalance between government and corporate bond markets: Government securities outstanding are close to 90% of GDP, supported by a predictable issuance framework. Corporate bonds remain only 15%–16% of GDP, far smaller than in major economies.
2. Banks as the default providers of long-term finance: Long-term financing needs continue even when markets are weak. Banks step in because no alternative mechanism exists to absorb and distribute credit risk.
3. High concentration of corporate debt in banks: Banks carry around 60%–65% of non-financial corporate debt, compared with 30% in the U.S. and 40% in Europe. This reflects financial structure, not lending choice.
4. Small size of the corporate bond market globally: Corporate bonds are less than 15% of GDP, compared with over 80% in the U.S., 55%–60% in Germany, and 45%–50% in China.
5. Limited market participation and weak liquidity: Issuance is mainly through private placements, ownership is concentrated among institutional investors, and secondary market liquidity is weak.
6. Restricted access and narrow investor base: Households and foreign investors play only a marginal role. Issuance is heavily skewed toward top-rated firms.
7. Overburdened bank balance sheets: Banks bear risks that mature financial systems distribute across markets. This concentration increases systemic fragility.

Consequences of a Bank-Centric Financial System

1. Severe maturity mismatch in bank financing: Banks rely mainly on short-term deposits but fund infrastructure projects that take 15–20 years to generate returns.
2. Higher vulnerability to economic shocks: Extreme maturity transformation exposes banks to sudden stress when project outcomes or cash flows weaken.
3. Direct absorption of project losses by banks: When projects stall, losses accumulate immediately on bank balance sheets instead of being distributed across investors.
4. Large fiscal cost of recapitalisation: Since 2017, the government has injected over ₹3.2 lakh crore into public sector banks to stabilise the system.
5. Transfer of private losses to public finances: Recapitalisation shifts credit losses to the public balance sheet, creating a hidden fiscal burden.
6. Opportunity cost in credit allocation: Capital tied in long-term corporate loans reduces lending capacity for small firms, exporters, and first-time borrowers.
7. Persistent constraints on SME credit: Even after repeated clean-ups and capital injections, lending to small and medium enterprises remains limited.

Impact on Monetary Policy and Financial Stability

1. Distorted transmission of interest-rate changes: Banks burdened with long-term exposures are reluctant to pass on higher borrowing costs when policy rates rise.
2. Restricted lending response during rate reductions: Impaired balance sheets prevent banks from expanding credit fully when interest rates fall.
3. Uneven adjustment of long-term borrowing costs: Long-term interest rates do not respond smoothly to policy changes due to concentrated credit risk.
4. Weak market-based repricing mechanisms: Deep bond markets normally transmit policy signals through yield adjustments across maturities. This mechanism remains limited.
5. Greater systemic fragility from risk concentration: Heavy reliance on banks to absorb long-term risk increases financial system vulnerability.

Initiative Taken to Rebalance Risk

1. Policy recognition of structural imbalance: Budget 2026 acknowledges that banks are carrying risks that functioning markets should absorb.
2. Market-making framework for corporate bonds: The budget proposes mechanisms to improve liquidity and trading in corporate bond markets.
3. Development of risk-transfer and hedging instruments: Budget 2026 proposes total-return swaps and bond-index derivatives to help redistribute and manage credit risk.
4. Infrastructure Risk Guarantee Fund: The budget proposes partial credit guarantees to support infrastructure financing and reduce direct bank exposure.
5. Recycling CPSE real estate through REITs: Budget 2026 proposes dedicated REITs to monetise CPSE real estate and expand the supply of market-ready assets.
6. Shift toward market-based allocation of risk: These measures aim to move long-term credit risk from bank balance sheets to financial markets.

Conclusion

Budget 2026 signals clear recognition that banks cannot continue as the main absorbers of long-term credit risk. Structural imbalance, weak corporate bond markets, and concentrated exposures have increased fiscal costs and financial vulnerability. The proposed reforms aim to shift risk from banks to markets. Sustained financial stability will depend on developing a deep corporate debt market that can price, distribute, and absorb long-term credit risk across a wider set of investors.

Question for practice:

Discuss how Budget 2026 signals a shift in India’s financial-sector approach by addressing the structural overdependence on banks and promoting market-based distribution of credit risk.

Source: The Hindu