Financial sector employees and workers joined a strike by trade unions on September 7 with a specific objective: to oppose a possible government decision to expand the presence of domestic and foreign private banks in India’s banking sector. The immediate provocation for their action was a “discussion paper” released by the Reserve Bank of India (RBI) delineating the “pros and cons” of permitting such an expansion. The objectives of permitting private entry noted by the paper are the oft-repeated ones: (i) the size and sophistication of the banking system needs to increase to accommodate the needs of a modern economy; (ii) the geographic coverage of the banks needs to be extended; and (iii) banking needs to be made more inclusive with increased access to banking services for all. Though the RBI does not support a change in policy, the note is bringing the issue back to the table.
The paper is in fact is quite explicit about the last of these objectives declaring that it is considering providing licences to a ‘limited number’ of new banks because: “A larger number of banks would foster greater competition, and thereby reduce costs, and improve the quality of service. More importantly, it would promote financial inclusion, and ultimately support inclusive economic growth, which is a key focus of public policy.”
This is indeed quite surprising inasmuch as the record of extant private banks in terms of meeting priority sector lending targets and offering services to geographically dispersed and underprivileged populations has been poor. Even to the extent that they have approached priority sector targets it has been because the government has redefined priority sector credit to include forms of “indirect finance”. In the case of agricultural credit for example, priority lending can include housing finance of certain kinds and lending to input providers such as seed companies.
This shortfall on the part of the private banks is not surprising, since lending to rural producers in a manner that is inclusive involves lending relatively small sums to a large number of remotely located borrowers. This inevitably raises transaction costs and given market or government determined ceilings to interest rates charged on priority sector credit, profits tend to be low or at times negative. If lending to rural borrowers has to be profitable it has to be at extremely high interest rates (as is the case even with microfinance institutions) that discourages the use of such credit for productive activities. If not, low profits or losses on such lending have to be cross-subsidised with profits earned by lending to other lucrative markets. The result would be lower profits on average, which public sector banks may be willing or persuaded to accept, but private banks, domestic or foreign, are unlikely to tolerate. Hence the inherent tendency among the latter is to circumvent norms with regard to lending to the priority sectors or to disadvantaged groups. Suggesting then that allowing entry of new private sector banks would make the financial system more inclusive is to go against both logic and experience.
If at all competition is being encouraged it must be for other reasons. But this too is surprising since competition in the financial sector has associated with it the potential for increased fragility. If easier entry conditions lead to competition between similarly placed financial firms, they would seek to attract depositors by offering higher interest rates. This forces them to lend to sectors offering higher returns which normally are sectors undertaking risky investments in pursuit of larger profits. When the principal financial intermediaries attract depositors by paying higher interest rates, there is an imperative to invest in assets offering high returns that are also risky and prone to default.
Moreover, as the experience in a number of countries shows, the liberalization of entry conditions, especially for foreign investors, does not lead to increased competition but to consolidation. The RBI’s discussion note recommends removing or diluting controls on the entry of new financial firms, subject to their meeting pre-specified norms with regard to capital investments. This aspect of liberalization would apply to both domestic and foreign financial firms, and caps on equity that can be held by foreign investors in domestic financial firms are likely to be gradually raised and done away with. Easier conditions of entry do not automatically increase competition in the conventional sense, since liberalization also involves freedom for domestic and foreign players to acquire financial firms and extends to permissions provided to foreign institutional investors, pension funds and hedge funds to invest in equity and debt markets. This often triggers a process of consolidation.
When Mexico chose to liberalise entry conditions for foreign investors into its banking sector in 1996, only 7 percent of total bank assets were controlled by foreign banks. Roughly one half of these foreign-controlled assets were in banks that did not engage in retail lending. These foreign de novo banks, as well as large foreign banks with no prior presence in Mexico, quickly began to purchase Mexico’s largest retail banks. By March 1997, 14 percent of bank assets in Mexico were controlled by foreign banks. By December 2002, the share of Mexican banks under foreign control increased to 66 percent. Today, the banks not under foreign ownership are few in number and extremely small. Thus measures aimed at enhancing competition could actually backfire.
Finally, what is of interest is the RBI’s willingness to consider permitting ownership of banks by business groups. We must recall that among the factors that motivated the nationalisation of leading private banks in 1969 was the evidence that a miniscule share of total credit was going to the agricultural sector and that two-thirds of advances by banks were being directed either to firms belonging to the same business group as the bank itself or to firms in which directors of the bank had an identifiable connection. Providing the basis for a return to such a situation is obviously contrary to the inclusion objective.
Thus, whether we look at it in terms of enhanced competition or in terms of financial inclusion, easing the terms of private entry would deliver results quite contrary to what the discussion paper expects. If yet ,the central bank is putting the issue on the table, it must be because of pressures – internal or external - it is unable to resist.
