India’s recent record of sustained high growth, sizeable economy, its self-sustaining agriculture, highly distributed production capability, leadership in services and technology and prudent fiscal management have emboldened it to aspire to be a developed nation by 2047, when the country will celebrate its century as an independent nation. Many economists and analysts have worked backwards to suggest what all are needed to be done to reach that status by that time. According to a study by the Reserve Bank of India in July 2023, the country will need to grow at a rate of 7.6% annually for the next 25 years to become a developed nation. To reach that level of sustained growth, India requires investment in physical capital and reforms across sectors covering education, infrastructure, healthcare and technology, the study said.
This essay will discuss specifically the role of the financial sector in furthering the cause of India becoming a developed nation by 2047. Sustaining high growth rates for a long period of time will require a stable, efficient and innovative financial system that meets the requirements of Indian households and businesses, and also the governments, without compromising macro-financial stability. Given the propensity of banks, non-banking financial companies (NBFCs) and fintechs to go overboard in their exuberance, we will deliberate on the guard rails for the banking system to chug on safely, securely and efficiently.
Given the development requirements of the country, capital accumulation needs to be at a faster rate with a focus on both domestic and external sources for capital formation. Demand for finance and capital will come from large-scale infrastructure projects, increased requirements in manufacturing capacity, expansion of the formal economy and increasing trade. Supply of finance and capital will have to be through mobilization of domestic savings, sustainable foreign capital, suitable types of financial institutions, instruments and products, channelling savings into investments, robust credit, and debt and equity markets.
India will need a large number of financial institutions to mobilize savings and channel them for investment. An increasing number of banks, NBFCs and the fintechs will have to emerge; these financial institutions will have to be of all sizes—small and equally large-sized banks will be needed to cater to the needs of financial inclusion and also to finance large projects. A variety of financial institutions will also be needed—for example, digital banks, wholesale/investment banks and even niche banks.
The suggested strategies will demand large and continuous capital infusion in banks and non-banks. The long-held policy preference for distributed holding vis-à-vis concentrated holding in banks will have to be revisited. Similarly, the reluctance or hesitancy in letting business and industrial houses, private equity and venture capital funds, and foreign banks have large stakes in banks will also need reviewing, given the large capital needs of banks. Suitable innovative financial instruments, offering a share in economic prospects minus control for such large stakes, will have to be explored.
It is a standard approach of financial regulation that anything growing fast needs greater regulatory attention. Very often, irrational exuberance and pro-cyclical overconfidence have resulted in market participants underestimating and overlooking the risks that brew in the system. It has become the responsibility of the regulators to anticipate plausible damages and accidents, and hence build speed-breakers, bulwarks and guard rails, besides keeping a hawk’s eye on the dynamics of the market developments. While discharging these responsibilities, the regulators also have to enable ample play for innovations.
The safety and soundness of the financial system and financial entities will continue to be the foundation for such guard rails. The playbook for such guard rails has been built under the aegis of the Bank for International Settlements’ (BIS) Basel Committee on Banking Supervision. The Basel norms have been fine-tuned over years based on developments and experiences in the world financial system. Employing these as appropriate to the country and its phase of growth will be the key for India’s next 25 years.
First, the regulator is on a special pedestal to see and anticipate risk build-up in a specific segment. Cautioning and red-flagging the market participants about this will be the starter in an upswing of the economy. (Last year, when the Reserve Bank cautioned banks and non-banks about the risk building up in the then high growing personal loan segment, the regulator was performing that role).
Second, countercyclical buffers and provisions for even standard assets will be another precautionary speed-breaker that the regulator will place. (The recent Reserve Bank of India’s prudential guidelines on project financing is an example of this approach).
Third, building up the war chest of capital and reserves of the financial entities will be the bulwark that the regulator would insist during the upswing. Typically, financial entities will be generating higher profits during this phase and it will be an ideal time for reserves to be enhanced with ease. The regulator should consider higher capital-to-risk assets ratio for the banks and non-banks in general.
Fifth, during the expected growth phase, India’s banks and financial institutions will grow into big sizes, both as individual entities and as groups. Too big to fail will be a greater concern. Hence, the regulator should also be considering entity-specific variations for higher capital ratios like for financial conglomerates and systemically important banks and financial entities.
One of the important contributing factors for the expected high-growth phase of the economy in general and the financial sector in particular will be the emergence of fintech companies. The role of fintech companies in furthering financial reach and inclusion, and adding efficiency to the banking and financial system in the coming years is very crucial. While the earlier claims or expectations that fintech companies will eliminate banks have since been put paid to and the Reserve Bank’s policy position that fintech companies cannot lend on their balance sheets have reduced direct financial risks, their proliferation and growth will entail customer protection issues and also possible indirect financial risks for banks and non-banks. Digital lending, buy-now-pay-later (BNPL) and pay-as-you-go kind of schemes have the inherent risks of going overboard and irrational exuberance on scale and speed at which these innovations grow. Misselling and overexposure are the common dangers. Further, enhanced risks relating to data protection and privacy issues, cybersecurity issues and operational risks will also have to be factored in. Besides, new concentration risks are also anticipated in Big Tech companies flexing their muscles in the fintech sphere.
While fintech companies are not regulated entities, one argument will be that they should be brought under direct regulation. However, that will be unwarranted and unmanageable. The current policy position of the Reserve Bank that fintech companies are best dealt with by indirect regulation through banks and non-banks will be suitable even for the high growth phase.
To conclude, as India is on its journey to become an advanced nation by 2047, the needed sustained high growth rate will in its wake manifest inherent risks for the financial system and entities. To manage these risks, the regulator has to be ever vigilant in anticipating risk events and placing precautionary and preventive regulatory measures so that the growth engines make a speedy journey along the regulatory guard rails safely.
R. Gandhi is a former deputy governor of the Reserve Bank of India.