View: How retail participation has changed the DNA of Indian markets

The resilience shown by India’s capital markets in the post-Covid era has been remarkable. They have stood firm in the middle of uncertain, and often unfavourable, global and domestic macroeconomic conditions. Increased retail participation, both directly and through mutual funds, has changed the DNA of Indian markets. There is every reason to celebrate the opening of over 100 million demat accounts, around 60% of them opening in the last two-and-a-half years.

Though we have a long way to go as compared to developed markets — adult population participation in capital markets in India is still only around 7%, compared to 70% in the US and 20% in China — it is an excellent beginning. It is in the interest of all stakeholders to keep this momentum going.

Excess liquidity, low interest rates and lack of alternative investment opportunities during 2021-22 have been factors pushing retail investors to capital markets. What may have not been adequately highlighted is the robust, dependable and efficient equities market regulatory framework that has provided confidence to retail investors. The ease of investing and increased digitisation of processes further facilitated this. That said, bringing in improvements is a continuous process.

Traditionally, the Indian financial sector has been dominated by banks. Increased domestic investor participation in markets have affected bank deposits. The fact that real returns from bank deposits have been negative during the last two-and-a-half years hasn’t helped banks. Having tested the waters in markets, investors are now better aware of available alternative investment opportunities.

Whenever RBI has increased the repo rate in the past, banks have been quick to raise their lending rates but sticky in increasing deposit rates, a typical monopolistic/oligopolistic behaviour. More than required liquidity in the system in the recent past also helped banks to keep deposit rates repressed. Now that the liquidity is being normalised, taking depositors for granted is not working.

Banks are being forced to increase deposit rates to compete with other alternative investment opportunities.

The increased credit demand on account of revival in domestic economic activity, working capital requirements and rising discretionary spending has further pushed the banks to vie for deposits. Loans increased year-on-year by 16% in September 2022, compared to 9.6% during FY2022 and 4.6% during FY2021. The incremental credit-deposit ratio this year has increased to a 9-year high of 112%, compared to an average of about 70% during the five-year preCovid period. Also, many banks have resorted to raising money from the market through bonds and corporate deposits.

All this has resulted in the disciplining of banks by increasing competition in deposit rate-setting, reducing operational opaqueness and rationalising their spread. If you happen to be a not-so market savvy senior citizen dependent on your savings for income flow, or a pensioner with no inflation indexation of pension, next time your bank raises deposit rate, thank the market, not the bank.

There is a crying need for bringing in a similar market-triggered disciplining of banks on the lending side. So, why shouldn’t bank loans compete with fundraisings through the bond market in an open and transparent manner? There ought to be a level playing field for these two alternative ways of raising debt.

Given the disintermediation associated with direct fund-raising from the market vis-à-vis borrowings from banks, corporate bonds can be positioned as a more efficient source of fund-raising by corporates. An efficient and liquid corporate bond market would even help banks in raising money to meet their credit demand, and for making investments as a part of their treasury operations. A developed bond market would result in better transmission of repo rates.

One often hears RBI officials claiming that the bond market is not behaving and needs disciplining. This is a wrong mindset. Let the market work freely, with RBI’s role coming into the picture only in the case of specific market failure situations.

RBI has been issuing directions to banks relating to ‘interest rate on deposits’ and ‘interest rate on advances’. These directions are quite prescriptive and keep changing frequently. For instance, directions on the benchmark under ‘interest rate on advances’ have moved over time from internal benchmark — base rate and then marginal cost of funds-based lending rate — to external benchmark. With the market providing competition at both ends (borrowing costs and lending rates), banks would be forced to bring in transparency and respond quickly to macroeconomic changes. There would be less and less need for regulatory intervention.

A gradual shift to ‘investor-issuer’ mindset, against the ‘depositor-borrower’ model, would reduce banks’ monopolistic dominance in the financial sector and provide alternatives to borrowers and investors. This would lead to the betterment of India’s financial system and economy.