By Ashvin Parekh, Managing partner, Ashvin Parekh Advisory Services LLP
If one were to analyse the gradual reduction of bank deposits and credit outflows, there could be a larger phenomenon at play. Against the backdrop of some core trends—including the shift from physical to financial assets, rise of retail investors, role of technology and fintechs, the gradual distancing by corporates from banking lending, and the growth of corporate bond market as well as the primary market for equity and debt instruments—the banking system will have to re-examine its role.We are witnessing clear disintermediation as household savings are progressively flowing from banks into capital markets and corporates are tapping equity and debt markets instead of depending solely on banks.
This typically exerts downward pressure on banks’ profits and the quality of their assets. The first major impact is the reduction of net interest margins, a major source of income for banks. The second impact is the gradual loss of high-value customers, followed by increased competition and pricing pressure. Banks, as we have witnessed in the past five years, have increasingly become slower in interest rate transmission of policy rates to protect their net interest margins. To arrest the profit decline, banks can pursue fee-based and advisory services, agency businesses, and digital financial products, leading to the gradual shift towards alternative revenue streams.There is one more dimension to the disintermediation impact—it affects the banks differently.
As disintermediation continues to accelerate, smaller banks, including co-operative banks, regional rural banks, and small finance banks (SFBs), will indeed come under significant profit pressure. This could create broader systemic challenges and potentially drive consolidation in the sector. SFBs are already seeing their profitability decline, with return on assets expected to drop to about 1.75% in FY25 (from 2.1% in FY24), mainly due to lower interest margins and higher credit cost. As more savings and borrowings move to capital markets and fintechs, the cost of maintaining customer deposits and sourcing loans rises for smaller banks.In addition to narrowing margins and rising costs, smaller banks will have gradual loss of traditional customers.
They depend heavily on traditional trust and rural and small-ticket banking. As savers and borrowers gain more direct access to digital platforms and capital markets, these institutions risk losing their core customer base, leading to further income pressure and gradual exclusion of low-income segments. One should also recognise that unlike large banks smaller banks may lack the resources to rapidly innovate, digitise, or diversify revenue streams.
They also face operational complexities if they enter new service areas to offset business lost to capital markets and digital channels. Smaller banks, policymakers, and the regulator will have to address the systemic challenges including those of financial inclusion, regional imbalance, and sectoral stability. One possible result could be the consolidation of smaller banks. There is a constructive outcome from the amalgamation among regional rural banks and state-level measures to merge smaller, weaker banks, particularly the small co-operative banks, as a response to profitability and viability concerns. There is potential for increased mergers, which could strengthen the efficiency and competitive landscape. The consolidation of public sector banks has also placed the merged entities to respond to the challenges of disintermediation far more effectively than they could have without consolidation.
Let us now examine a macro and stronger driver of disintermediation. Is the retail investor’s shift from putting their savings in bank deposits to capital market products like stocks, mutual funds, systematic investment plans (SIPs), and particularly exchange-traded funds (gold and silver), a sign of growing financial literacy in India?There are signs of financial literacy impacting disintermediation, but the picture could be nuanced. In the Indian context, there is certainly a positive correlation between the two. Studies confirm that higher financial literacy is associated with more sophisticated financial behaviour such as greater willingness to invest in mutual funds and equities, better debt management (of their EMIs), and diversified portfolios.
In many ways, it is evident from the surge in demat accounts, which have grown to more than 200 million, suggesting growth of 20% year-on-year in the past five years. Likewise, the assets under management of mutual fund companies have been growing at a dramatic pace, and so has the investment in the new asset classes. The surge in financial asset purchases with bullion underlying has been phenomenal. Then there is the retail surge in SIP growth. Month-on-month, the mutual fund industry is mobilising an increasing amount in SIPs with new investors entering the markets, signalling increased retail awareness and participation.
This reflects not just digital accessibility but also a basic understanding of investment instruments and vehicles. It has led to short-term behaviour and an increased risk appetite. While many new investors are seeking higher returns, some are influenced by short-term gains and market euphoria. The question that may arise is whether this is a healthy sign. There are some positives to this trend, including aspects such as financial empowerment and inclusion leading to market expansion, investment choices, reduced household reliance on low-yield deposits, and long-term wealth creation. It is also evidence of progress. Studies reveal that steady gains in average financial literacy have a direct association with a shift to institutional savings and invested assets. Products like SIPs are a long-term vehicle, demonstrating some shift toward systematic and disciplined investing, not just speculation.
There are risks and caveats to this as well. A knowledge gap remains and herd mentality, the fear of missing out, and short-term reward chasing may expose inexperienced investors. There can also be a potential for asset bubbles resulting from unchecked risk appetite and trend-based investing, which could erode trust if market corrects sharply.
Disintermediation could lead to pressure on the banking system and demand that the industry become more efficient and innovative to look for alternative revenue opportunities and/or consolidate. However, disintermediation driven by rising retail participation and financial awareness is largely healthy for the Indian financial system, if paired with continued financial efforts, robust investor education, and protection against mis-selling and market excesses. It will call for deepening true financial understanding and prudent regulatory oversight to guard against behavioural excesses and systemic vulnerability.