India's hidden credit constraints: Issue lies in pricing, regulation

Even with abundant banking liquidity, banks continue to scramble for deposits. Overall, India’s credit ecosystem remains small relative to the size of our economy. 

All this reflects a combination of tax incentives, regulatory structures, and monetary conditions that suppress the attractiveness of fixed income and constrain credit expansion. In turn, this has wider implications for our asset markets and external balance. 

Sizing the problem 

Data from the Reserve Bank of India (RBI), the Securities and Exchange Board of India (Sebi), and the World Bank suggests that India is a global outlier in the relative size of our credit markets. India’s domestic credit, across banks, non-bank finance companies, and corporate bonds, stands at just 60 per cent of equity market capitalisation. The global average is 115 per cent.

Even in the United States, with its equity culture, credit is 95 per cent of market capitalisation. In countries like Japan, Germany, and South Korea, this ranges between 125 per cent and 195 per cent. China, with its investment-heavy growth model, is at a staggering 310 per cent. 

India’s shallow credit base reflects structural constraints in credit formation. 

The pricing of fixed income 

Low returns from fixed income weaken the foundations of our credit ecosystem. 

First is the fiscal drag. Taxing interest income at marginal income tax rates makes it harder for post-tax returns to clear the expected inflation hurdle. In recent times, this has sparked a migration of household savings away from fixed income into equities. This, in turn, reduces the pool of long-term savings that underpin credit markets. 

Second is the impact of monetary intervention. For FY26, the RBI will conduct record open market operation (OMO) bond purchases of  ₹8 trillion, effectively absorbing 77 per cent of net central government bond supply through secondary market operations. While intended to inject liquidity and support growth, this anchors risk-free rates below where the market would otherwise clear the deficit. 

Economists argue that cooling consumer price inflation justifies lower interest rates. However, in any market economy, prices should ultimately be determined by supply and demand. When rates are influenced by large-scale interventions, their

signalling role becomes less clear. 

All this results in fixed-income returns being seen as insufficient compensation for inflation and duration risk. 

  Regulatory constraints 

Overlaying this are banking regulatory requirements such as the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). These are global post-crisis standards to ensure the resilience of banks. Their system-wide effects merit attention. 

LCR requires banks to hold high-quality liquid assets (HQLA) to cover a 30-day “stress” outflow. Regulations prescribe how flight risk is computed. Deposits over 30 days have zero imputed outflow. In contrast, “sticky” retail deposits under 30 days may carry a 7.5 per cent runoff, while “volatile” wholesale deposits may carry a 40 per cent outflow. 

To manage LCR, banks prioritise term deposits, followed by retail demand deposits, with wholesale short-term deposits being a last resort. Any adverse shift in the mix forces banks to hold more HQLA, in turn requiring additional deposits. Similarly, NSFR demands “reliable stable funding”, or deposits exceeding one year to back long-term lending. If there is insufficient growth in long-term deposits, long-term lending will be curtailed. 

The deposit paradox 

System-wide, deposits are created by bank lending, government spending funded by banks, or foreign exchange (FX) inflows. They are drained by the repayment of bank loans, an increase in currency in circulation (CIC), or FX outflows. 

While loans create their own deposits, the LCR burden is neutralised only by term deposits. As the deposit mix shifts toward shorter-tenor or less stable categories, banks must hold more HQLA, necessitating additional funding. 

Deposits from individuals have reduced from 60 per cent of all deposits 10 years ago to 52 per cent now, with no compensatory shift in the extent of term deposits. Alongside, any net FX outflows and CIC spikes drain deposits, and strain LCR management. While the ratio of CIC to deposits has remained under control, there have been FX outflows in recent years. 

All this explains the current scramble for deposits, despite ample banking liquidity. 

There is also a “fallacy of composition” here. LCR and NSFR address the idiosyncratic risks of a bank run. System-wide, a run usually reshuffles deposits between banks. While buffers enhance the resilience of individual banks, they overcompensate at an aggregate level, constraining the system-wide ability to lend. 

External spillovers 

With post-tax returns from fixed income struggling to beat inflation expectations, domestic flows into equities have risen. In recent times, this flow has outstripped fresh equity issuance, leading to pockets of overvaluation. This creates an environment conducive for foreign investors to pare exposure, likely contributing to the recent moderation in net foreign investment. 

Low domestic interest rates also compress the dollar-rupee forward premium. Especially during times of currency volatility, this encourages the hedging of imports and rupee investments, discourages the hedging of exports, and induces domestic savers to invest overseas. These add pressure on the rupee while further reducing domestic deposits. 

The path forward 

Addressing these interconnected issues requires a calibrated and multi-pronged approach. 

First, a gradual move towards a more asset-agnostic, savings-friendly taxation framework would allow risk-return considerations, rather than tax differentials, to guide asset allocation. This would help stabilise fixed-income flows, support balanced asset valuations, and create room for consistent foreign investments across asset classes. 

Second, on LCR and NSFR, we must remain aligned with global best practices but avoid tightening beyond them. Additional buffers, while prudent in isolation, aggregate to a systemic burden that stifles the economy they aim to protect. 

Third, monetary and currency interventions must be assessed not only for their immediate objectives, but also for their higher-order effects on savings behaviour, asset markets, and financial intermediation. This is especially crucial if the focus of intervention fluctuates periodically between currency stability and interest rate anchoring. 

India’s financial system has achieved significant depth in equity markets. The next phase of development requires a comparable strengthening of credit markets across banking and corporate bonds. 

Without this, the paradox of liquidity without sufficient credit will likely persist.

The writer is a former whole-time member, Sebi.

The views are personal