Context

• India’s Union Budget 2026 introduces several financial-sector initiatives, including the creation of a market-making framework for corporate bonds, etc.
• While these measures may appear technical, they collectively reflect a significant shift in policy thinking.
• Rather than merely reforming banks, the government is attempting to address a deeper structural imbalance in India’s financial architecture.
• The core issue is that Indian banks carry long-term credit risks that, in mature economies, are absorbed by financial markets.
• Consequently, the reforms represent a move away from a bank-dominated system toward a market-oriented financial structure.

Structural Imbalance in the Financial System

• Public discussions often attribute banking distress in India to weak governance, political interference, and poor risk management.
• Although these factors exist, they do not fully explain recurring banking crises. The more fundamental problem is institutional.
• India lacks a deep corporate bond market, forcing banks to finance large and risky projects.
• India possesses a relatively well-developed government securities market, with outstanding sovereign bonds approaching 90 percent of GDP.
• However, its corporate bond market is shallow, amounting to only about 15-16 percent of GDP, far smaller than those of the United States, Germany, or China.
• Because the economy still requires long-term investment financing, banks inevitably step in to fill this gap.
• As a result, banks hold around 60–65 percent of non-financial corporate debt, compared with roughly 30 percent in the United States and 40 percent in Europe.
• The difference arises not from managerial competence but from financial system design.

Maturity Mismatch and Financial Fragility

• Banks are structurally unsuited to finance long-term infrastructure projects.
• They fund themselves primarily through short-term deposits and therefore depend heavily on liquidity and depositor confidence.
• Yet they are expected to finance projects such as highways, power plants, ports, and telecom networks that require 15 to 20 years to generate returns.
• This creates a severe maturity mismatch: short-term liabilities funding long-term assets.
• When projects fail or are delayed, losses appear suddenly on bank balance sheets. In market-based systems, such losses are distributed gradually across investors.
• In India, however, they accumulate within banks, making the financial system more fragile and vulnerable to shocks.

Fiscal Costs and Credit Misallocation

• The consequences of this imbalance extend beyond banking stability. Since 2017, the government has injected over ₹3.2 lakh crore into public sector banks to recapitalise them.
• These interventions stabilised the financial system but effectively transferred private corporate losses onto taxpayers, functioning as a hidden fiscal burden.
• Additionally, large corporate exposures tie up bank capital that could otherwise support smaller enterprises.
• This helps explain why small and medium-sized firms continue to face credit shortages despite repeated bank recapitalisation.
• Thus, the problem is not merely insufficient credit but misallocated credit.

Impact on Monetary Policy and Role of Budget 2026 Reforms

• Impact on Monetary Policy
  • The concentration of risk within banks also weakens monetary policy transmission.
  • When interest rates rise, banks burdened with long-term exposures hesitate to pass on higher costs.
  • When rates fall, impaired balance sheets limit fresh lending. Consequently, borrowing costs in the real economy adjust unevenly to policy changes.
  • In contrast, deep bond markets allow interest rates to reprice smoothly across maturities, improving the effectiveness of central bank policy.
• Role of Budget 2026 Reforms
  • The Budget 2026 initiatives attempt to correct this structural deficiency.
  • Measures such as improving corporate bond market liquidity, introducing hedging instruments like total-return swaps, providing partial credit guarantees for infrastructure, and expanding market-ready assets through REITs are designed to distribute credit risk beyond banks.
  • By enabling institutional investors, pension funds, and other market participants to participate in long-term financing, these reforms aim to create a functioning corporate debt market.
  • In essence, the reforms seek to transform the financial system from one where banks act as the economy’s primary risk-bearers to one where markets share and price risk more efficiently.

Conclusion

• India’s financial challenges stem less from banking mismanagement than from systemic design.
• A shallow corporate bond market has forced banks to shoulder long-term credit risk, creating financial fragility, fiscal burdens, distorted credit allocation, and weak monetary transmission.
• The financial-sector measures in Budget 2026 therefore represent more than incremental reform; they signal an effort to rebalance the financial architecture.
• Whether these initiatives succeed will determine whether India evolves into a resilient, market-based financial system or continues relying on banks as the economy’s shock absorbers of last resort.