Banking on inclusionhttps://indianexpress.com/article/opinion/columns/banking-on-inclusion/

Banking on inclusion

New bank licences should be awarded to players who can demonstrate that inclusion is compatible with financial viability

New bank licences should be awarded to players who can demonstrate that inclusion is compatible with financial viability

The race for new bank licences is on. The deadline for filing applications is July 1. The RBI will then constitute a committee to screen the applications,with the intention to issue the first set of licences by March 2014. The outcomes may well have a bearing on the long-term health of the banking sector.

Diverse players are said to be in the fray — leading industrial houses,non-bank finance companies (NBFCs),investment banks,public sector finance companies and,at least,one infrastructure company. The RBI will use “fit and proper” criteria,but the RBI governor has indicated that not all applicants satisfying these criteria will get a licence. He has said that there is no point in going through the process only to issue two or three licences,but has declined to indicate a precise number. The critical question is: what criteria,other than “fit and proper”,should the RBI use? This question is best addressed if we are clear what the primary objective is. Is it greater competition (and hence greater efficiency),or is it financial inclusion?

One measure of competition is the concentration ratio,defined as the share of the top three banks in total banking assets. India’s concentration ratio of 35 per cent is among the lowest in the world. Comparable averages are: advanced economies 60 per cent,Asia 40 per cent,and Latin America 55 per cent. It is hard to argue,going by this indicator,that India’s banking sector lacks competition.

There are some who argue that competition is limited by the dominance of public sector banks (PSBs) that account for 70 per cent of assets in banking. It is said that Indian banks’ net interest margin (the difference between the yield on loans and investments and the cost of funds) as a proportion of assets of 3 per cent is higher than that in many other economies. Margins need to be brought down — and this is best achieved by licensing players with deep pockets,namely,industrial houses.

Both parts of the statement can be challenged. Higher margins in Indian banking could reflect higher risks. Margins of new private banks are higher than those of PSBs,so increasing the number of private players may not be the answer to high margins. If banks are to meet the higher capital requirements proposed under new international norms,and if they are to invest in financial inclusion,it is better that margins stay on the higher side.

As for letting in industrial houses to inject serious competition,such a move carries its own dangers. Most people seem to think the principal danger is that of “inter-connected lending”,that is,banks promoted by industrial houses will find ways to channel funds into various entities connected with the house. This could place public deposits in jeopardy. In India’s present environment,this particular concern may be somewhat misplaced. The better known industrial houses have too much to lose by letting a bank in their control fail. By and large,they have stood behind borrowings of weak firms within their group in the interests of protecting their reputation. They will do what it takes to make a success of their banking venture. It is their very success,however,that we need to fear. For three reasons.

First,industrial houses represent concentration of economic power. Adding a bank to an industrial house would add enormously to its clout. We can do without further concentration of economic power in a scam-ridden system. Second,given its clout,an industrial house may be able to circumvent or influence regulation — or what is called “regulatory capture”. Banking regulation is one of the strong points of the Indian economy,and the RBI justifiably enjoys a high reputation. Any weakening of the banking regulator risks financial instability. Third,the success of an industrial house could come at the expense of existing banks. Banks promoted by industrial houses could take away some of the best borrowers and depositors. They could poach the best people by paying a lot more. This will push up costs across the system. It will make life particularly difficult for PSBs already hard pressed to attract and retain people.

Some would say this is what competition is all about: success must go to the efficient and the weak must perish. In banking,however,we have to contend with systemic failure. We do not want the entry of industrial houses to create individual banks that are efficient and a banking system that is weaker. In short,the case for greater competition in Indian banking — and,that too,to reduce margins — is not obvious. And even if we do need more competition,industrial houses may not be the best candidates.

The priority in banking today must be financial inclusion. On a variety of measures,India lags behind other emerging markets on financial inclusion. We need to extend banking services to underserved segments in both the urban and rural markets. We need players who can demonstrate that inclusion is compatible with financial viability. If this is accepted,the appropriate criterion for awarding new bank licences falls into place. We do not need more banks that will focus on retail lending and working capital finance,while nominally meeting the stipulation of having 25 per cent of their branches in unbanked areas.

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Bank licences must be issued to those who can convince the RBI that they can use innovative business models to achieve financial inclusion. These could include existing NBFCs that are not part of industrial houses as well as completely new players. This will give us financial inclusion as well as more competition without undermining financial stability.

The writer is professor at IIM,Ahmedabad