How badly does India need banking? (bank based financial system vs market based financial system?)

Ajay Shah writes on recent Bank recapitalisation (history here and current specifics here).

He asks several questions related to this policy and much of which has already been discussed.

But this first question caught my attention:

Q1 How badly does India need banking?

There are other countries (e.g. US, UK, Japan, China) where the banking system is quite large. But in India, banks do not matter that much to the economy: we are a market dominated economy. The 2400 large companies alone have equity market capitalisation of Rs.131 trillion. If we were able to count the value of equity in the remaining firms, it would add up to a lot more. In contrast, the credit by all banks to all private persons (summing up across firms and individuals) stands at Rs.80 trillion. Banking is less important to India than is the case elsewhere.

Hmm…We always think the opposite. India is always seen as more of a bank system and not a market based system.

This takes one to the debates over bank based financial system vs market based financial system in the late 1990s. The Anglo Saxon world was seen as market based and Europe was seen as bank based. Cometh the 2008 crisis, we realised how the buck finally stops at banks as all the so-called market based financial mechanisms were directly or indirectly connected to the banks.

So, I think it is not really right that banking is less important to India than is the case elsewhere. Eventually one would realise how banks have aided in all this market capitalisation and are equity investors in many of these firms. It is all like this castle made of playing cards and one only sees the deep interconnections when one thing fails as seen in 2008 crisis.

But having said this, what is interesting how these numbers of Bank credit vs equity market capitalisation stack up today.  One should do a time-series plot of these two to see when equity markets take over bank credit. It is another testimony to how Indian equity markets have developed over the years. We just look at noisy statistics of IPO and Sensex levels. But the main theme here is how equity markets have overtime provided such a complimentary role to banking funds over the years…

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