Permitting banks to issue senior long-term bonds will help correct asset-liability mismatches (ALMs) and provide a tool to improve liquidity coverage ratio by extending funding outflows, said India Ratings and Research (Ind-Ra).

Growing divergence in the tenors of loans and deposits has resulted in rising ALMs in government banks. For some banks, there is even a shortage of ready collateral that could be used to repo with the Reserve Bank of India in a liquidity squeeze.

Senior bonds are rated at the same level as banks' long-term issuer rating in the absence of a bank resolution regime and are not treated like loss-absorbing hybrid capital. Government banks have easy access to long-term investors such as insurance and pension funds and hence are well placed to tap this market.

The existing guideline that permits banks to issue infrastructure bonds has not found favour with investors, perhaps due to the implicit link with a sector that has been struggling to perform for some time. Senior bonds issued globally by Indian banks have a good investor base. A similar (and possibly larger) market can be created among domestic investors. Indeed, investors take comfort from the benefits of government support, which is reflected in Ind-Ra's stable long-term issuer rating of government banks during the economic slowdown in FY13 and FY14.

The Indian banking system's dependence on short-term liabilities has grown to a point where refinancing pressures are hurting margins. This also poses unique policy challenges, including diluted monetary transmission, a persistently flat-to-inverted yield curve and crowding out corporates from the commercial paper market.

Deposits maturing within one year increased to almost 50% of the total deposits in 2014, up from 33% in 2002. The ratio dipped in 2013 after growth in advances had moderated, before rising in 2014. A significant part of these deposits had maturities within six months and, for some banks, included a growing share of wholesale money market borrowings. The share has grown independent of the interest rate cycle and will likely be explained, paradoxically, as a strategy by banks to preserve margins by remaining at the short end of liability tenor.

The domestic yield curve is likely to remain flat to inverted, unless issuance volumes shift to the long-end of the curve. Regulatory initiatives that help banks address this challenge and push long-term savings will benefit the economy in the long run.