Adding more depth and vibrancy to the bond market was one of the few unfinished items on Raghuram Rajan’s agenda. Hence, the RBI’s ‘mini-bang’ bond market reforms last week did not come as a surprise. While the measures are no panacea for the many ills plaguing India’s bond markets, they contain significant steps to widen participation in corporate bonds, enhance liquidity and encourage more issuers and buyers to take the market route to debt. The package is well-timed, as credit flow to industry has been stalling due to banks’ bad loans problems.

The RBI, drawing mainly on the recommendations of the HR Khan committee, suggests three distinct sets of measures. One, in order to improve the appetite for corporate bonds, banks and primary dealers will soon be allowed to offer corporate bonds as collateral in place of government securities (g-secs) in the Liquidity Adjustment Facility (LAF) window. While only top-rated issuers may benefit from this move, and that too with suitable haircuts on valuation, this change can be path-breaking in enhancing both appetite and liquidity for corporate bonds. Opening up corporate bond repos to registered brokers engaged in market-making may aid price discovery. Allowing banks to extend more guarantees on lower-rated bonds (credit enhancement) can shore up this neglected segment of the market. Two, in an effort to improve access for Foreign Portfolio Investors (FPIs) they are to be granted direct access both to corporate bonds and the negotiated dealing platform for government securities. Such dis-intermediation can reduce costs and boost yields for FPIs, but their overall demand will still be curbed by the statutory cap on their participation. Three, the proposal to curb banks’ exposure to large accounts through explicit borrowing limits (by FY19), is likely to force large borrowers to actively explore primary bond issues. This shift will increase the supply of good quality bonds and curb concentration risks for banks. Overall, while these ideas will undoubtedly boost the bond markets, they may also hit the business of banks. Direct corporate participation in the money markets may reduce the need for treasuries to maintain high current account balances. Large companies migrating to market borrowings may force banks to explore small-ticket lending. In the short run, this could well add to pressure on revenues and profitability for banks. But in the long run, active competition from the bond markets will force banks to ensure quicker transmission of policy rates.

However, these measures may not be enough to address structural issues such as the lack of a market for lower-rated bonds, or an illiquid secondary market. Here, nudging domestic institutions such as insurance firms, provident funds and banks to move away from their risk-averse strategies is critical. These institutional investors should be encouraged to build better in-house capabilities on credit assessment. But then, this is not the RBI’s remit. The Centre and other financial market regulators too need to take up the cause of bond market development.

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