Transformation of Credit market in India

Broadly, a credit market is a market for borrowing money in the form of bank loans, bonds, etc. The credit market is also known as the debt market since it deals in fixed-income instruments like bonds, treasury bills, commercial paper, and debt offerings such as notes and securitized obligations, collateralized debt obligations (CDOs)/(mortgage-backed securities), and credit default swaps (CDS). These fixed-income instruments are issued by central and state governments, other government bodies, and municipal corporations. Banks, financial institutions, corporates, etc. also can issue fixed-income instruments. Credit market equilibrium occurs at the real interest rate where the quantity of loans supplied equals the quantity of loans demanded. At this equilibrium real interest rate, lenders lend as much as they wish, and borrowers can borrow as much as they wish.

Before the 1991 reforms, the credit market in India was tightly regulated. Bank credit was the principal focus of monetary policy under the credit planning approach. The credit market was characterised by credit controls and directed lending. Multiple credit controls existed in the form of sectoral limits on lending, limits on borrowings by individuals, and stipulations of margin requirements. Lending interest rates by all types of credit institutions were administered. Banks needed prior approval from the Reserve Bank, if borrowing exceeded a specified limit (under the Credit Authorisation Scheme), and selective credit controls in the case of sensitive commodities. Credit markets were also strictly segmented. Short-term working capital requirements are catered by commercial banks and long-term capital requirements of industry, are financed by industrial financial institutions. This led to several inefficiencies in the credit market.

A wide range of regulatory and structural reforms were initiated in the early 1990s, to improve the effectiveness of the credit market. The reforms included interest rate decontrols, cuts in reserve and liquidity requirements, an overhaul of priority sector lending, deregulation of entry barriers, strengthening of prudential regulations and supervision, restructuring, and partial privatization of public sector banks through stock exchanges.

While the stipulation for lending to the priority sector has been retained, its scope and definition have been fine-tuned by including new items.  The earlier restrictions on commercial banks’ lending for project finance were lifted. Lending interest rates were deregulated to achieve better price discovery and efficient resource allocation. This resulted in the growing sensitivity of credit to interest rates and enabled the Reserve Bank to employ market-based instruments of monetary control. The Statutory Liquidity Ratio (SLR) has been gradually reduced to 18 per cent. The Cash Reserve Ratio (CRR) was reduced from its peak level of 15.0 per cent maintained during 1989 to 4.5 per cent at present. The reduction in statutory preemptions has significantly augmented the lendable resources of banks.

With the emergence of the capital market becoming an important source of finance and the renewed role of banks in term financing, the development of financial institutions (DFI) has been increasingly exposed to greater competition. The entry of new players associated with the processes of decontrol, deregulation, and globalisation, has led to increased competition for financial intermediaries across different segments. Access of FIs to assured sources of long-duration/concessional funds from the Government, particularly ‘SLR bonds’ that were subscribed to by banks and insurance companies has been gradually phased out making FIs tremendously dependent on market borrowings. As a consequence, development financial institutions (DFIs) are required to raise funds from the capital market. Due to the removal of administrative controls on the interest rate structure, it has become increasingly difficult for DFIs to raise long-term funds. This in turn has affected their ability to offer competitive rates to their borrowers. As a consequence, two large development financial institutions (DFI) viz. ICICI and IDBI converted themselves into commercial Banks. In a developing financial market like India, the credit market being a main source of funds, traditionally, played an important role in sustaining growth. It has become highly competitive even though the number of credit institutions has reduced due to merger/conversion, licence withdrawal of unsound NBFCs, and restructuring of urban co-operative banks and RRBs. Credit institutions now offer a wide range of products. They are also free to price them depending on their risk perception.

The transformations of the following financial markets have created a robust ecosystem for financial transformation in India.

Transformation of the banking sector in India

Transformation of the Money market in India

Transformation of Government securities market

Transformation of the Foreign exchange market in India

Transformation of the Capital market in India

Transformation of the Credit market in India

Transformation of Payment Systems in India