Ancient roots, modern vision can build India’s financial sector

India has a rich history of financial innovation, dating back to the 4th–6th century CE when Guilds (Shrenis) of merchants and artisans pooled resources, shared risks, and financed large ventures, much like today’s investment trusts.

As India seeks to become a high-income economy by 2047, it needs to build on this past to create a dynamic, inclusive and resilient financial system that can help raise the investment-to-GDP ratio from the current 33.5 to 40 percent, promoting economic growth and large-scale job creation.

Challenges and opportunities

Over the past few years, India’s financial assets have grown to nearly 190 percent of GDP, with non-bank financial institutions (NBFIs) and capital markets providing almost half of private sector credit. This shift away from traditional banking is necessary for a country to achieve high-income status. 

Nonetheless, this ongoing transformation brings its own challenges. With multiple players reporting to different regulators, stronger macro-prudential surveillance will be needed. Besides, the growing number of intermediaries can lead to suboptimal lending decisions, higher borrowing costs, and stagnating financial inclusion.

On the other hand, the rise of capital markets and NBFIs - that are generally less risk-averse than traditional banks - presents an opportunity to mobilize long-term financing. The challenge, however, will be to meet the surging demand for investment across various sectors - infrastructure, MSMEs, sustainability, and the sunrise sectors.

Key reform areas

Four key reform areas can help India build a modern financial sector that can support its goal of reaching high-income status by 2047: 

1. Unlocking fixed income markets. Expanding the capacity of insurance and pension funds to invest beyond government securities can boost domestic demand for corporate bonds which have been lagging behind emerging market peers. Other areas for reform include introducing a savings scheme with a favorable tax regime for debt securities, developing credit enhancement products (see Bridging India’s Vast Infrastructure Financing Gap), and launching innovative financial instruments such as mini-bonds, securitization platforms, and covered bonds. 
2. Increasing MSMEs’ access to finance. While partial credit guarantee schemes like the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) have reduced the banks’ perception of risk in lending to MSMEs, the financing gap remains at a substantial 11 percent of GDP.  Further structural reforms are needed. First, the asymmetry of information still needs to be reduced. For this, credit Information companies will need to be allowed to process non-credit data, while Account Aggregator should be able to process data other than clients’ assets. Second, a unified secured transactions law needs to be established, and land registries digitized. And third, insolvency frameworks need to be strengthened by improving the capacity of National Company Law Tribunals (NCLTs). 
3. Enhancing climate finance. The Niti Aayog has conservatively estimated that India needs to invest $250 billion per year until 2047 to prepare its energy systems to achieve net zero. Currently, however, this falls significantly short, especially from domestic sources. To accelerate these investments, India will need to implement a stronger regulatory framework, explore incentives for green financing, and promote blended finance solutions. A revised legal framework for Corporate Social Responsibility would also help mobilize large amounts of concessional resources.
4. Fewer but better State-Owned Financial Institutions (SOFIs). State owned banks, NBFIs, insurance companies, and pension funds still dominate India’s financial system, albeit with a declining footprint. In 2023, these held 57 percent of total financial sector assets, down from 64 percent in 2017. While SOFIs have so far played a crucial role in development finance, their fiscal costs have also been high (over $38.8 billion was allocated to recapitalize state-owned banks between FY18-21). In addition to advancing the government's privatization agenda and aligning corporate governance with international best practices, SOFIs should also be incentivized to mobilize additional private financing, through co-lending, credit enhancement and risk-sharing mechanisms, guarantees, and pooled investment vehicles. SOFIs can also play a critical role in deepening capital markets and scaling up green financing. At the same time, the government will need to reassess Priority Sector Lending to align it with the evolution of the financial sector. 

Strong institutional collaboration will be essential

Drawing on its rich history of financial ingenuity, India must now adopt a collective and well-coordinated approach for the financial sector. Strong institutional collaboration which unites regulators, policymakers, and financial institutions will be essential. Reorienting the role of SOFIs, unlocking fixed income markets, modernizing credit infrastructure, and enhancing climate finance will also be vital. Ultimately, these efforts will help expand job opportunities for India’s growing young cohorts, enabling more citizens to be a part of India’s growth story.

To learn more about India’s financial sector, click here.