Business

The more efficient intermediary?

In India, the capital market has recently moved into the limelight

In all economies, whether developing or developed, there are basically two principal channels for mobilising savings into investment. Both the banking system and the capital market exist side by side connecting savers with investors in the first instance and thereafter allocating resources efficiently to the several users of the economy.

Banks are the original intermediaries making their money by collecting deposits from savers and lending them to borrowers. The difference between the interest they charge on loans and that paid on deposits is the ‘spread income’ and it is this that has sustained banks everywhere for a long time. On the other hand, the capital market, though having a hoary tradition in many countries including India (the BSE is 125 plus years old), has grown in stature only after a process called disintermediation took hold. Far from being a process that scuttles the role of banks and others, disintermediation is really about challenging the dominance of existing institutions (banks).

Competition for the savings of the community and in due course for the right type of borrowers as a rule improves efficiency. Customers of banks, whether depositors or borrowers, get a choice. Entities, besides banks, step in and perform the intermediation role. For the financial sector as a whole, both banks and the capital market are important and in most countries there is a healthy co-existence. However, for a variety of reasons, one or the other, the banking system or the capital market, has become dominant in every country. Those with a strong Anglo-Saxon tradition, the U.K., the U.S. and Australia, have financial sectors dominated by capital market products. In India, Germany and Japan, it is their banking systems that claim primacy.

It may seem odd that until now the Indian financial market should be comprehensively dominated by the banking system. This is because the better regulated banking system has been able to serve the needs of the saver as well as the investor. As a general rule, banks are better equipped to appraise a project and monitor it after the loan is sanctioned. Experience in India, however, suggests that as a rule banks are prone to be risk averse.

Capital markets have helped in raising resources for even comparatively risky projects. But in India, where capital market regulation has only recently taken big strides, equity capital is still expensive and debt capital practically non-existent. Besides, the healthy functioning of the capital market depends on the existence of an alert and enlightened investor class willing to take on errant companies. In India, at present, it is the capital market that seems to be in the limelight for a variety of reasons.

Foreign institutional investors continue to favour India. They are investing not just in the secondary markets but in the primary market as well. The two mega share issues of DLF and ICICI Bank were well subscribed on the back of a strong overseas interest. In fact, the ease with which the two large issues could sail through points to a healthy deepening of the new issue market. The two benchmark indices, the Sensex and the Nifty, are well supported at their current high levels.

There is further evidence of vibrancy in the capital market. Mutual funds have been mobilising record sums. The assets under their management crossed Rs. 300,000 crore recently. Perhaps most important of all, those achievements have come in the wake of some enlightened regulation. The institutional structure of the capital market is on a sound footing. All this should suggest that the capital market is finally getting its due and that the overwhelming importance of the banking system to the financial sector is finally getting corrected.

C. R. L. NARASIMHAN

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