Indian banks: From credit provision to liquidity provision?
In my last three blog posts, I wrote about the emergence of large pools of domestic risk capital in India, the crowding out of foreign risk capital, the shrinking share of bank deposits in household financial savings, and the rapid growth of asset managers relative to banks.
In this post, I discuss how the Indian banking system and credit markets in general are likely to be reshaped by the changing competitive landscape, and by emerging new business opportunities.
Let us start with international bond markets which have become less important as a source of funding for the Indian corporate sector in recent years. Several factors have played a role here including global uncertainties and risk perception. But one factor that is important in the long term is the reduced cost advantage of foreign currency debt. Historically, Indian interest rates have been much higher than US interest rates making dollar debt attractive even after taking possible rupee depreciation into account. Post the Global Financial Crisis, the difference between the yields of ten year Indian Government bonds and US Treasury bonds hovered around 4%, and during periods like the taper tantrum and the pandemic, this differential crossed 6%.
But more recently, the gap between Indian and US long term government bond yields has narrowed to around 2½%. If we approximate expected inflation over the next 10 years in India and the US by their respective inflation targets of 4% and 2%, we get an expected inflation differential of 2%. The international Fisher condition states that Indian long term yields should exceed US yields by this inflation differential of 2%. Viewed in this light, recent yield differentials between India and the US are not materially higher than what is to be expected in a friction-less rational market with no country risk premium for local currency debt. India's comparative macroeconomic stability and its credible inflation targeting regime make it likely that this situation might endure.
Apart from cost advantages, Indian companies were in the past drawn to global bond markets because of their greater depth and the sheer availability of credit. Here again, Indian sources of funding (banks, private credit and domestic bond markets) have become much deeper and reliable. This again reduces the need to tap global markets and accept the currency risk that comes with that.
A good example of this greater depth of financing options in India was a deal last year in which a large Indian construction company tapped private credit to borrow $3.4 billion in Indian rupees. Apart from the size of the deal what was noteworthy was that the borrower was close to the bottom edge of an investment grade rating from Indian rating agencies. At a sufficiently juicy yield, Indian credit markets are now open in size to low rated borrowers.
To my mind, Indian credit markets are now where Indian equity markets were 15 years ago: the investors are predominantly (but not exclusively) foreign, but the market is in India. Over the next decade, I expect Indian investors (family offices, high net worth individuals and institutional investors) to become a larger part of this market mirroring the evolution of Indian equity markets in the previous decade.
As this happens, I think that Indian banking would move to a originate-warehouse-distribute model. It is quite likely that housing and other personal loans would be securitized in larger volumes. Even in corporate credit, banks may focus on providing liquidity rather than on funding. For example, banks have recently been allowed to provide financing for mergers and acquisitions. Globally the norm is that banks provide committed credit facilities to the acquirer which provides assurance of deal completion to the target company. After a successful acquisition, the borrower usually refinances the bank debt with bond market borrowing over a period of time. Conceptually, the ultimate source of M&A financing is the bond market (and asset sales), and the bank loans are more like bridge finance. Even in normal course of business, companies that finance themselves in the bond markets would typically have a line of credit from banks to meet liquidity shortfalls. Even asset managers would seek bank lines of credit to meet unanticipated redemption requirements. Banks are uniquely positioned to sell liquidity because of their privileged access to the central bank lending window.
Banking is likely to become more complex as these forces play out in coming years. Commercial banks that are able to think like investment banks are likely to be the winners in this process.
Posted at 2:34 pm IST on Tue, 17 Feb 2026 permanent link
Categories: banks, bond markets, Indian financial sector
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