The Hidden Tax, Why Budget 2026’s Financial Reforms Are a Bid to Unburden India’s Banks
Budget 2026, presented against the backdrop of a complex global economy and domestic aspirations for accelerated growth, contained several proposals that, on the surface, appeared technical and incremental. A market-making framework for corporate bonds. Development of total-return swaps and bond-index derivatives. An Infrastructure Risk Guarantee Fund. Recycling of Central Public Sector Enterprises (CPSE) real estate assets through dedicated Real Estate Investment Trusts (REITs).
Individually, these are modest measures. Collectively, however, they point to a deeper recognition: India’s banks are shouldering risks that, in more mature financial systems, are priced, traded, and distributed through markets. This structural imbalance has quietly overburdened bank balance sheets, made the financial system more fragile than it needs to be, and imposed a hidden tax on the public exchequer through repeated recapitalisations.
The budget’s financial sector proposals are an attempt to correct this imbalance—to shift risk from the banking system to the capital markets, where it can be more efficiently distributed and absorbed. Whether this shift gains momentum will determine whether India’s financial system becomes more resilient or continues to rely on banks as the economy’s shock absorber of last resort.
The Structural Imbalance: Banks as Default Risk Warehouses
When Indian banks struggle, the usual explanations focus on weak governance, political interference, and poor risk management. Each contains some truth. But taken together, they miss the larger issue. Over time, India has asked its banks to bear risks that, in more mature systems, are handled by markets.
The problem begins with a structural imbalance between the government bond market and the corporate bond market. India has built a reasonably deep government bond market, supported by the Reserve Bank of India and a predictable issuance framework. Government securities outstanding are close to 90% of GDP, comparable to many large economies.
The same cannot be said of corporate bonds. At around 15-16% of GDP, India’s corporate bond market is less than half the size of China’s and barely a quarter of that in the United States or Germany. This gap matters because economies do not stop needing long-term finance simply because markets are missing. When bond markets are shallow, someone else must step in. In India, that “someone” has been banks.
Today, banks carry roughly 60-65% of all non-financial corporate debt, compared with about 30% in the US and 40% in Europe. The difference is not managerial skill or prudence; it is architecture. Where markets can price and redistribute credit risk, banks lend selectively. Where they cannot, banks become the default warehouse for risk.
The Mismatch: Short-Term Money for Long-Term Projects
This is not what banks are designed for. Banks fund themselves largely through short-term deposits and are sensitive to confidence. Yet they are expected to finance projects—highways, power plants, ports, telecom networks—that take 15 or 20 years to generate cash flows. This mismatch in duration forces banks into extreme maturity transformation, increasing vulnerability to shocks.
When a bank makes a 20-year loan funded by deposits that can be withdrawn at any time, it is taking a significant risk. If depositors lose confidence, the bank can face a liquidity crisis even if the underlying loan is sound. If the project stalls or cash flows disappoint, the loss lands directly on the bank’s balance sheet.
In a market-based system, such long-term risks are distributed. A pension fund or insurance company buys a corporate bond with a 20-year maturity, matching its long-term liabilities. If the project falters, the loss is absorbed by a range of investors, not concentrated in a single institution. The system is more resilient because risk is dispersed.
The Fiscal Cost: Recapitalisation as Hidden Tax
The consequences of India’s bank-centric model have been visible and costly. When projects stalled or cash flows disappointed, losses were not absorbed gradually by markets. They landed abruptly on bank balance sheets. And when bank balance sheets were impaired, the government stepped in.
Since 2017, the government has injected more than ₹3.2 lakh crore into public sector banks. These recapitalisations stabilised the system, but they also quietly transferred private credit losses onto the public balance sheet. This is the hidden tax of a bank-centric financial system. The money used to recapitalise banks could have been spent on schools, hospitals, or infrastructure. Instead, it was used to cover losses that, in a more developed market system, would have been borne by investors.
There is also a less visible opportunity cost. Capital tied up in long-term corporate loans is capital that is not available to small firms, exporters, or first-time borrowers. This helps explain a familiar paradox: even after repeated clean-ups and capital injections, bank credit to small and medium enterprises remains constrained. Banks, burdened with large exposures to big corporates and infrastructure projects, have little capacity left for the smaller borrowers who are the engines of employment and innovation.
The Shallow Corporate Bond Market: A Vicious Cycle
India’s corporate bond market remains shallow by international standards. Bonds outstanding amount to less than 15% of GDP, compared with over 80% in the US, around 55-60% in Germany, and 45-50% in China. Issuance is overwhelmingly through private placements, meaning bonds are sold to a small group of institutional investors rather than offered publicly. Ownership is concentrated among a narrow set of investors—primarily mutual funds and insurance companies—and secondary market liquidity is weak. Households and foreign investors play only a marginal role, and issuance is heavily skewed toward top-rated firms.
With such limited depth and participation, the bond market cannot meaningfully absorb or price credit risk. A company that wants to raise long-term funds has few options beyond approaching a bank. And banks, facing limited competition from the bond market, have less incentive to price risk accurately or to develop sophisticated credit assessment capabilities. The shallow bond market and the bank-centric system reinforce each other in a vicious cycle.
The Monetary Policy Transmission Problem
The concentration of risk in bank balance sheets also weakens monetary policy transmission. When the Reserve Bank of India raises interest rates, banks already burdened with long-term credit exposures are reluctant to pass on higher costs fully. They fear that higher lending rates will trigger defaults on existing loans. When rates fall, impaired balance sheets constrain fresh lending. The uneven adjustment of long-term borrowing costs despite changes in policy rates reflects this distortion.
In contrast, deep bond markets transmit policy signals more smoothly. When the central bank changes its policy rate, yields across the bond curve reprice quickly. Investors rebalance their portfolios. The cost of capital for corporations adjusts in real time. This transmission happens through markets, not through the slow and imperfect process of bank lending rate adjustments.
Budget 2026’s Proposals: A Gesture Toward Rebalancing
The measures announced in Budget 2026 are an attempt to correct this long-standing structural imbalance. Each proposal addresses a specific constraint:
Market-making framework for corporate bonds: By creating designated market-makers with obligations to provide two-way quotes, the framework aims to improve liquidity in the corporate bond market. Investors are more willing to buy bonds if they know they can sell them when needed.
Total-return swaps and bond-index derivatives: These instruments allow investors to gain exposure to corporate bonds without holding the underlying securities, and to hedge risks. They also enable the transfer of credit risk from banks to other investors. A bank that has made a loan can use a total-return swap to pass the economic risk to a counterparty, freeing up capital and reducing concentration.
Infrastructure Risk Guarantee Fund: This fund will provide partial credit guarantees for infrastructure bonds, reducing the perceived risk for investors. Infrastructure projects are inherently risky, with long gestation periods and regulatory uncertainties. A guarantee mechanism can crowd in private investment by absorbing some of that risk.
Recycling CPSE real estate through REITs: Real Estate Investment Trusts allow illiquid real estate assets to be converted into tradable securities. By bundling CPSE properties into REITs and selling units to investors, the government can unlock value and create a new class of marketable assets. This expands the stock of investible securities and provides an alternative to bank lending.
Collectively, these measures gesture toward reallocating risks away from banks and into markets. They recognise that the current model is unsustainable—that banks cannot continue to be the economy’s shock absorber of last resort without endangering the financial system and imposing repeated costs on the public exchequer.
The Road Ahead: From Gesture to Momentum
Whether these measures will achieve their intended effect depends on implementation. Market-making frameworks require willing participants; total-return swaps require a robust legal and regulatory infrastructure; guarantee funds require careful design to avoid moral hazard; REITs require investor appetite and a supportive tax regime.
More fundamentally, shifting risk from banks to markets requires a cultural change. Borrowers accustomed to banking relationships must learn to access bond markets. Investors must develop the capacity to analyse credit risk. Regulators must balance innovation with stability.
But the direction is clear. Budget 2026 signals that India recognises the structural imbalance in its financial system. The question now is whether this recognition will translate into sustained momentum for reform, or whether the gestures will remain gestures, and banks will continue to bear the burden alone.
Q&A: Unpacking Budget 2026’s Financial Reforms
Q1: What is the core structural problem that Budget 2026’s financial reforms are trying to address?
A: The core problem is that India’s banks are shouldering risks that, in more mature financial systems, are priced, traded, and distributed through markets. Because the corporate bond market is shallow (only 15-16% of GDP), companies seeking long-term finance have little choice but to approach banks. Banks now carry 60-65% of all non-financial corporate debt, compared to 30% in the US. This concentration of risk makes the financial system fragile, forces banks into dangerous maturity transformation (funding long-term loans with short-term deposits), and has required over ₹3.2 lakh crore in government recapitalisations since 2017—a hidden tax on the public.
Q2: Why is a shallow corporate bond market a problem for the economy?
A: A shallow corporate bond market means that long-term credit risk cannot be distributed across a range of investors. In developed markets, pension funds and insurance companies buy 20-year corporate bonds, matching their long-term liabilities. If a project fails, losses are absorbed by many investors. In India, those losses land directly on bank balance sheets. This also crowds out lending to smaller borrowers, as banks’ capital is tied up in large corporate exposures. Additionally, it weakens monetary policy transmission, as banks burdened with long-term loans are slow to adjust lending rates when policy rates change.
Q3: What specific measures in Budget 2026 aim to deepen the corporate bond market?
A: The budget proposes several measures: (1) a market-making framework to improve liquidity in corporate bonds; (2) introduction of total-return swaps and bond-index derivatives to allow risk transfer and hedging; (3) an Infrastructure Risk Guarantee Fund to provide partial credit guarantees for infrastructure bonds; and (4) recycling of CPSE real estate assets through REITs to expand the stock of marketable securities. Collectively, these are designed to make corporate bonds more attractive to investors, improve liquidity, and shift long-term risk from banks to markets.
Q4: What is the “hidden tax” referred to in the analysis?
A: The “hidden tax” is the fiscal cost of repeated bank recapitalisations. Since 2017, the government has injected over ₹3.2 lakh crore into public sector banks to cover losses from bad loans. These losses originated in the private sector—from corporate borrowers who defaulted—but were ultimately socialised, paid for by taxpayers. This is a hidden tax because it represents public money that could have been spent on schools, hospitals, or infrastructure, but was instead used to stabilise banks. A deeper bond market would have distributed these losses across investors, reducing the burden on the public exchequer.
Q5: Will these measures be enough to solve the problem?
A: They are a step in the right direction, but implementation will be critical. Market-making frameworks require willing participants; derivatives require robust legal infrastructure; guarantee funds need careful design to avoid moral hazard; REITs require investor appetite and supportive tax treatment. More fundamentally, shifting from a bank-centric to a market-based system requires cultural change: borrowers must learn to access bond markets, investors must develop credit analysis capabilities, and regulators must balance innovation with stability. The budget signals recognition of the problem; whether it achieves lasting change depends on sustained momentum.
