Financial Liberalization in India and the Bank Lending Channel of Monetary Transmission†

Abstract

The financial reform process has given banks in India a great deal of freedom on both the assets and liabilities (or sources and uses of funds) sides of their balance sheets. To the extent that, financial liberalization has opened up new non-reservable and non-insured sources of funds (like Certificates of Deposits and new issue of equity), any attempts by the central bank to influence bank lending by withdrawing reserves (leading to a fall in deposits) from the banking system could be countered by raising money from these alternate sources leaving bank lending unchanged. It is in this liberalized regime that the 'bank lending channel', which emphasizes the presence of asymmetric information in the financial markets, becomes particularly relevant. In this article we attempt to verify if bank lending is constrained by the availability of insured deposits and whether there exist subgroups of banks that are less constrained. We find that banks in general are constrained in their lending by the availability of insured deposits and these constraints are more severe for those banks that lend predominantly against collateral. In India more than 85 per cent of bank lending is against collateral. This implies a potentially important influence of the bank lending channel.