Easing Banking Regulations in India

General Studies-3; Topic: Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.

Introduction

India’s GDP is projected to grow from $3.7 trillion (2023-24) to $7 trillion (2030-31), backed by strong fiscal policies, robust digital and physical infrastructure, and financial sector expansion.
However, to sustain this growth, higher capital expenditure (capex) and increased credit flow are essential.
The current regulatory framework for banks, including Statutory Liquidity Ratio (SLR), Liquidity Coverage Ratio (LCR), Cash Reserve Ratio (CRR), and Priority Sector Lending (PSL), restricts credit availability, making a case for easing banking regulations.

The Need for Increased Investments

Capital Requirement for a $7 Trillion Economy

- To achieve a $7 trillion economy, India needs $2.5 trillion in investments, requiring an investment-to-GDP ratio of 34%.
- The government’s fiscal deficit limits public investment, making private and household savings crucial for capital formation.
- Private sector investment has declined, with the investment-to-operating cash flow ratio falling from 114% (2008-09) to 56% (2023-24).

Challenges in Financial Intermediation

The Declining Role of Banks in Capital Mobilization

- Banks now receive only 40% of household savings, down from 50% a few years ago, as consumers prefer mutual funds and pension schemes for better returns.
- High pre-emptions reduce banks’ lendable resources, pushing up interest rates and discouraging corporate and MSME borrowing.

The Burden of Regulatory Pre-emptions

- Banks must hold up to 30% of deposits as non-lendable reserves due to:
  - SLR (26%) – Higher than the regulatory requirement of 18%, due to LCR constraints.
  - CRR (4%) – No interest earned, further limiting bank liquidity.
- This reduces credit supply and increases borrowing costs, slowing economic expansion.

Impact of New LCR Guidelines for Digital Deposits

- Upcoming LCR norms for digital deposits will require banks to invest an additional 2-2.5% of deposits in liquid assets, reducing lending capacity further.

Rethinking Banking Regulations: Do We Need Both LCR and SLR?

Global Best Practices vs. India’s Approach
Globally, only LCR is mandatory, while India imposes both LCR and SLR, leading to excessive capital retention in low-yield assets.
In most countries, CRR (which earns no interest) is included in High-Quality Liquid Assets (HQLA), but India excludes it, reducing bank profitability.
Basel III norms recommend that banks assess their liquidity needs independently, yet RBI’s rigid regulations create compliance burdens.

Addressing Liquidity Challenges

Limited Access to Credit for MSMEs
Large corporates access capital through equity markets, bond markets, and bank credit, but MSMEs face credit shortages.
Priority Sector Lending (PSL) targets exceed 60%, leading to mispricing of credit risks.
The PSL framework must evolve to reflect new economic priorities and current GDP composition.

Credit Growth and Exchange Rate Management

Credit Growth Lower than Nominal GDP Growth

- India’s credit growth lags nominal GDP growth, raising concerns about capital formation and financial stability.
- The credit-to-deposit (CD) ratio must be re-evaluated, ensuring banks can raise debt and equity efficiently.

Exchange Rate Management and Liquidity Impact

- Defending the rupee against the strong dollar drains liquidity without stabilizing the currency in real terms.
- Overvaluation of the rupee reduces export competitiveness, impacting trade balance and forex reserves.

Way Forward

Revisiting SLR and LCR mandates to free up bank liquidity and lower lending costs.
Encouraging private-sector investment through policy stability and demand stimulation.
Updating PSL norms to reflect India’s evolving economic structure.
Ensuring credit growth aligns with nominal GDP growth to sustain investment-led expansion.
Deepening capital markets and reducing regulatory barriers for bond market growth.
Aligning digital banking costs with international fee models to maintain financial viability.

Conclusion

India stands at a critical juncture in its financial evolution. With progressive banking reforms, better financial intermediation, and improved liquidity management, the banking sector can drive India’s transformation into a $7 trillion economy.

Practice Question:

India aims to become a $7 trillion economy by 2030-31. Discuss the role of banking sector reforms in achieving this target. Suggest measures to improve credit availability while ensuring financial stability. (250 words)