The job of the financial industry is to allocate capital efficiently. Capital that is saved by savers (mostly households) and used by companies for investment. The two main legs of this industry are banks and mutual funds. Does the structure of both lead to an efficient allocation of savings to those most deserving of it?

First, the banking industry. This industry is dominated by public sector banks (PSBs), which the government had nationalised, and which, today, control 70 per cent of deposits, or household savings.

The PSBs are in a sad state, with non-performing loans of some ₹10 lakh-crore. They keep needing more capital from the majority owner, viz. government. So, basically, the savings of households and the tax of citizens is being used to fund the lifestyles of a few, mainly because the structure of this industry so permits. Lending by PSBs was, earlier, based more on telephonic instruction than on a proper evaluation. Hence, the continuing problem of non-performing loans.

One would imagine that a businessman would, at some point, decide to cut his losses and get rid of businesses that he could not manage. Not true of Governments. This is because the capital of a business man is his own money and for PSBs it is not. But now that the government is, belatedly, contemplating privatisation of a few weak banks, it has run into another obstacle. Since nationalisation was done through legislation, privatisation needs legislative approval. In a pre-election year, this is thought politically unwise, even though it is logical and necessary.

So, the banks, especially PSBs, are not doing their job of allocating capital efficiently, largely because of how the industry is structured and hence, managed.

The fund industry

The mutual fund industry has grown rapidly in recent times thanks largely to the low interest rates offered by banks to depositors, which is not enough to cover inflation. Earlier, households, which save some 30 per cent of their income, used to invest their savings in both physical assets (real estate, gold, etc.) and financial assets (bank deposits, corporate deposits, equity, bonds, etc.). There has been a shift from the former to the latter, and, within the latter, money is flowing out of deposits and into mutual funds.

The flow of savings into these funds is what is helping keep stock markets high despite FII selling.

But here, too, it is a select handful of nine stocks that are outperforming, up between 20-50 per cent since January, while others are flat, or down by up to 42 per cent.

In the BSE 500, as many as 300 of the 500 stocks are down by 10-90 per cent.

Is the structure of the industry responsible? Probably. The pay of fund managers is linked to the performance of the fund relative to an underlying index. So, the natural inclination is not to be too underweight on a stock, especially a heavyweight, for fear that may lead to underperformance and hence, lower pay.

As recently happened in the US, this concentration can pose a risk. US indices were rising thanks to the FAANG stocks (acronym for Facebook, Apple, Amazon, Netflix and Google which is now Alphabet). These would compensate for the fall in other stocks and keep the index high. But recently FAANG stocks, led by Facebook, have fallen, and so has the index. A similar thing can happen here, because of concentration which, in turn, is thanks to the structure explained above.

(The writer is India Head — Finance Asia/Haymarket. The views are personal.)

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