Banking Structure Plausible Vision, Flawed Approach of RBI

T T Ram Mohan (ttr@iimahd.ernet.in) teaches at IIM Ahmedabad.

The author benefi ted from discussions with R Krishnamurthy, former managing director of SBI Life.

Following the crisis of 2007, there is renewed focus the world over on banking structure. This encompasses a number of related matters: the size, scope and number of banks, consolidation and concentration, and the degree of competition.

Getting the structure right is about getting the balance right between efficiency and stability in banking while striving for greater inclusion. A misplaced focus on efficiency can bring on a banking crisis and associated economic turmoil. Focusing too much on stability can breed inefficiency, which could prove a drag on growth and lead to a crisis as well. Inclusion is a priority but, if not pursued efficiently, it will undermine stability and cannot be sustained.
Last August, the Reserve Bank of India (RBI) issued a discussion paper titled “Banking Structure – The Way Forward” in which it touches upon a range of issues on the subject of banking structure. Posing the issues is, of course, timely, especially as the RBI has at its helm a new governor with a mandate to shake up things.
However, this paper should have preceded the policies on new private banks and foreign banks. It would then have provided the opportunity for a vigorous debate on the RBI’s view of how the banking structure needs to evolve. By unveiling the policy on licensing of private banks first and then the policy on foreign banks within three months of the discussion paper being issued, the RBI seems to have put the cart before the horse.
Four-Tier Structure
The RBI’s proposed reorientation of the banking structure is summarised in a table in an annexure to the document. The RBI envisages a four-tier structure for Indian banking. The first tier will comprise three or four very large global Indian banks and foreign banks. At the next tier will be a set of national players. The third tier will have regional players, comprising old private sector banks, regional rural banks and multi-state urban cooperative banks (UCBs). At the bottom will be local area banks, single-state UCBs, state and district cooperative banks.
All but the first tier already exist. The important changes proposed are: a new set of global banks to be created through mergers; consolidation amongst existing players in the second and third tiers; entry of new players, perhaps with differentiated licences and through a process of continuous authorisation; and small banks at the local level. Is this the way to go? In what follows, we touch upon some of the issues raised in the paper.
(i) Consolidation: The paper raises the issue of whether we need Indian banks that are global in size. It mentions that only two Indian banks, the Sate Bank of India (SBI) and ICICI Bank, figure in the top 100 in the world, with ranks of 38 and 99 respectively. This is something that often appears to give policymakers and bankers a terrible complex.
The paper gives a number of reasons why such a complex is misplaced. One, no amount of consolidation is going to produce a global size Indian bank. Two, growing bigger has to go hand in hand with sophistication in risk management, a broad enough suite of products and technological expertise. Three, consolidation may run counter to another objective, namely, financial inclusion. Given these weighty arguments, one fails to see why we should be in a tearing hurry to create the first tier at all, whether through mergers among the larger public sector banks (PSBs) or mergers among the larger private sector banks.
Perhaps, consolidation is required, not to create the first tier but to create fewer players in the second tier? One way to answer the question is to look at the degree of concentration in Indian banking, how it compares with that in advanced as well as emerging economies. Going by the three-firm or five-firm concentration ratio, India appears neither too fragmented nor too concentrated. The RBI paper cites another measure used for concentration, the Herfindahl ratio, to show that fragmentation among public and private sector banks has increased between 2002-03 and 2011-12. But does the ratio today compare unfavourably with that in other economies?
The big headache for government today is the demands that PSBs make on government for capital. But merger is hardly the answer, it can only create bigger headaches. It is naive to suppose that mergers of large PSBs with widely varying culture can produce results. (The limited experience with mergers in the public sector thus far has been uninspiring.) The answer to the problem of capital is to opt for lower government shareholding in PSBs – and to do so selectively.
To begin with, let the government identify four or five of the smaller PSBs that have shown little sign of improvement in recent years and announce that it will settle for a decline in its shareholding to, say, 33%. This will allow private capital to flow into these banks, while government control remains. Eventually, the government can contemplate a fuller divestment from these banks.
This will also allow the government to focus on the bigger PSBs that retain their competitive strengths. Strengthening the larger PSBs while diluting government presence in the weaker ones is more realistic than attempting mergers, which will only end up weakening the entire public sector. It is also more likely to find acceptance amongst bank unions.
(ii) Differentiated Licensing: The RBI paper contends that there is a case for banks that will be licensed for particular areas, such as infrastructure financing, wholesale banking and retail banking with a focus on small and medium enterprise (SME) financing. These banks would be subject to a different set of reserve and capital adequacy requirements, exposure norms and restrictions on accessing deposits. The downside is that specialised institutions may not be able to practise financial inclusion, observe priority sector lending norms and would be exposed to both funding and concentration risk.
One wonders what the discussion is all about. We do have non-banking financial companies (NBFCs) that specialise in lending to particular segments (whether retail or wholesale), that are restricted in their access to deposits and are not subject to priority sector norms. It is not clear in what way the system stands to gain if we had banks with the same characteristics (except that banks are subject to tighter regulation). We will only be rechristening NBFCs as banks!
If the RBI does wish to opt for specialised institutions, it would have to permit less onerous reserve and priority sector requirements and access to retail deposits. But this would amount to turning the clock back on the philosophy of having a level playing field amongst those who choose to operate as banks.
ICICI and IDBI opted to convert themselves into banks once the concessional funding on which they had operated was withdrawn. When the conversion happened, they did not have the benefit of much regulatory forbearance on statutory requirements. Similarly, in allowing NBFCs to convert into banks, the RBI has not been in favour of giving any concessions. That is why many NBFCs have opted not to become banks.
Given a level playing field, players have tended naturally towards the universal banking model. This is proof that functional specialisation does not make sense without special dispensation of the sort that we chose to move away from.
(iii) Continuous Authorisation: The paper moots the idea of continuous authorisation of bank licences instead of a “stop and go” policy. It makes a number of arguments in favour of continuous authorisation. It would create contestability in the banking sector and foster greater efficiency; a gradual increase in the number of banks would be less disruptive than a sudden increase at a point in time; regulatory resources would not be strained while screening applicants; and players would have ample time to plan their business model.
Whether there is adequate competition in the system or not cannot be judged continuously. One has to pause after allowing in new players and take a view at a point in time whether competition is too much or too little, whether any segment – public, private and foreign – is overemphasised or under-emphasised, and whether supervisory capacity is equal to the task. The RBI paper argues that such authorisation is already available for foreign banks. This misses the point that foreign banks have not had the same freedom as domestic banks to open branches. A compromise, which the paper mentions, would be to announce a licensing policy and specify the period after which it would be reviewed.
(iv) Role of Small Banks: Financial inclusion is a priority. Is this best done by a small number of large banks or a large number of small banks? The paper poses this question and attempts some tentative answers based on the experience of a few other economies and India’s own.
The problem with smallness today is not so much a lack of economies of scale: with mobile banking and other technologies, it is possible to conceive of small-sized operations that are viable, especially as there is freedom of pricing in a deregulated environment. Neither lack of scope nor sectoral or geographical concentration are big problems, given the inherent granularity of small loans and the track record of repayments of small borrowers. The biggest issue is governance. Whether it is cooperatives, microfinance institutions (MFIs) or local area banks, we have not been able to put in place effective mechanisms of governance for the small banks in our system.
One possible response could be to live with a large number of failures. But this requires an effective resolution regime and timely support of depositors, especially since the depositors of small banks are likely to be amongst the most vulnerable in society. The United States can, perhaps, live with the risks of failure because it has an effective resolution regime in place. This is, alas, not true of India. Liquidation of banks takes years; depositors have to wait endlessly to get their money back. If the experience with MFIs shows anything, it is that the social and political costs of poor regulation are unaffordable. It would be unwise, therefore, to place great reliance on small banks per se for fostering financial inclusion.
A more sensible alternative would be to push large banks to practise inclusion either by setting up subsidiaries with a different cost structure altogether or to get large banks to partner small banks or MFIs. In dealing with large banks, governance is taken care of. Partnering with small banks gives access to the necessary network and manpower at a lower cost. On this, we must now await the recommendations of the latest committee on financial inclusion constituted by the RBI.
Conclusions
In sum, the basic intent of the RBI appears to be to shrink the space occupied by PSBs (over 70% of assets in the banking system) and, by the same token, to expand the role of private and foreign banks. There is a plausible case to be made for such a vision but, in trying to realise it, we need clarity on some essentials. One, the importance of diversity of ownership in banking should be made clear as also the role of the public sector as sheet anchor. Two, there should be no attempt to expedite the process through mergers; instead, this should happen by allowing freer entry of new private and foreign players. Three, we must eschew any attempt at grandstanding in the name of creating global players. Four, we can do without a fresh set of regulatory challenges created by the entry of corporate houses.

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