Risk-based Pricing: Are India's Credit Markets Moving Towards this Paradigm?

Abstract

There is growing consensus amongst economists that a sound financial system is essential for an economy to achieve a high and stable rate of growth. The financial sector reforms in India in the last decade have enjoyed many important successes. At the same time, India's financial system has many glaring shortcomings. Perhaps the most serious concern for many is the fragility of some of our financial institutions. For others, it is the growing liabilities of the government while yet others worry that our arm's length securities markets have not taken off, and seem to be periodically laid low by scandal after scandal. These problems may be linked. At a conceptual level, because of a variety of institutional deficiencies, there appears to be too little private risk bearing capacity in the economy. The stance of public policy, as well as the increasing competition in credit markets, in numerous aspects, has served to stifle the ability of regulated finance companies to bear risk. What this means then is that even though the liberalization of the economy has increased competition and hence the level of risk in the economy, the risk is not being allocated well. Because risk is concentrated in the wrong places, incentives of key players are distorted, and economic outcomes are sub-optimal. This paper seeks to outline the key elements of a financial system that India will need in the quest for higher growth rates and the challenges and solutions chalked out for the same.