Banking Sector Reforms

Dilution of efficiency based principles and its implications for finacial markets


From UPSC perspective, the following things are important :

Prelims level: Bond markets, SLR

Mains level: Paper 3- Issues with the financial markets in India

The article discusses the themes of the recently published books by Viral Acharya and Urjit Patel. Both the books deal with the issues with the financial markets in India


  • Two recently published books by Viral Acharya and Urjit Patel throws light on the issues with India’s finance market and role of RBI and the government.

Importance of financial markets

  • Banks along with bond and equity markets oversee the matching of savers with borrowers.
  • Without financial markets, businesses would be restricted to investing out of retained earnings alone.
  • The financial markets have to satisfy the return appetites of savers while minimising their risk exposure.

Undue preference to fiscal interest of the government

  • A major theme of Acharya’s book is the rampant subjugation of the financial and monetary infrastructure to the fiscal interests of the government.
  • Consider, for example, the conduct of monetary policy.
  • Since bank assets are marked to market, cuts in interest rates induce treasury gains for banks that effectively recapitalises them.
  • Consequently, rate cuts are preferred by governments needing to inject capital into public sector banks (PSBs).
  • For the same reasons, liquidity injections, which raise bond prices, are preferred to liquidity absorptions.
  • Fiscal compulsions of government can induce liquidity policies that have the opposite effect on the rate-setting by the MPC.
  • This contradiction is further complicated by the fact that the RBI is also the debt management agency for the government.
  • As a debt management agency, RBI’s key tasks is to sell government bonds at the highest possible price.
  • Pressures for regulatory forbearance in recognising NPAs often arise from the government wanting to avoid having to recapitalise PSBs.
  • The sameexplains the fact that stock exchanges in India having a 30-day disclosure norm for registered borrowers who default on their bank loans.
  • The standard in developed capital markets is immediate disclosure.
  • But that would induce an overnight rating downgrade of the concerned borrower thereby triggering additional capital provisioning needs for the lending bank.

Conflict in government owning the PSBs

  • Patel’s book deals with conflicts inherent in the state owning the banks that control about three-fourth of total banking assets in India.
  • The primary problem with PSBs is that governments have used them as tools for macroeconomic management.
  • PSBs are regularly used for resource mobilisation to finance fiscal deficits.
  • The government often announces credit policies rather than having the banks allocate credit based on risk-return management criteria.
  • PSBs are the favoured instrument for meeting employment targets, supporting farmers through loan write-offs, etc.

What are the implications of government owning PSBs

  • This kind of state interface naturally induces extreme levels of moral hazard in the behaviour of both debtors and creditors.
  • PSBs are not incentivised to exercise due diligence since they expect regulatory forbearance and recapitalisation in the event of rising NPAs.
  • The dilution of efficiency-based principles for banking has implications for all borrowers.
  • Creditworthy borrowers pay the risk premia to cover the riskiness due to unhealthy borrowers.
  • The worsening risk pool of borrowers is partly to blame for the fact that long term borrowing rates have remained stubbornly high despite repeated rate cuts by the MPC over the past 18 months.

3 Problems and 3 Reforms


  • There are three obvious problems with the existing architecture.
  • The first is the state ownership of banks.
  • The second is the chronically high fiscal deficit run by the consolidated public sector.
  • The third is the widespread perception that market regulators work under close government direction. 


  • Dealing with this will require, at a minimum, three reforms.
  • First, there has to be a wholehearted attempt at privatisation of PSBs.
  • Second, the RBI needs to be relieved of its public debt management role.
  • Third, the RBI has to be empowered to act independently of the government.


The growth of firms, which is a key driver of productivity and growth, requires well-functioning financial markets. India has a lot of work to do.

Back2Basics: How cuts in interest rates induce treasury gains for banks?

  • Falling rates across the debt markets increase the demand for instruments that pay higher interest.
  • At this stage, prices of bonds which banks had bought when interest rates were high rise.
  • Hence, the value of government securities that banks have bought for the SLR requirement rises.
  • This increases profits as banks record the market value of these securities in their books.
  • Under this process, called marking to market, organisations record profits/losses in their books on a daily basis without actually booking any profit or loss.
  • So, more SLR bonds the bank holds, the higher its mark-to-market profit.
  • The other reasons bank profits rise when interest rates fall are pick-up in growth as companies borrow at lower rates as well as improvement in liquidity.


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