Moneycontrol
May 02, 2017 05:59 PM IST | Source: Moneycontrol.com

Big banks: India wants to make, US wants to break, neither can find a solution

As both governments try to prevent the ills of the banking system from spilling over to the economy, Japan presents a cautionary tale.

Big banks: India wants to make, US wants to break, neither can find a solution

Shishir Asthana

Moneycontrol Research

In India, there is increasing talk of merging smaller banks to create a behemoth that will take on larger global players and fund big infrastructure projects. Finance Minister Arun Jaitley has already set the ball rolling for bigger banks by getting state-owned State Bank of India to absorb its smaller associates.

Contrast this with the narrative in the US, where President Donald Trump said over the weekend that he is thinking of breaking up the giant Wall Street banks.

While a straightforward comparison cannot be made between big banks in the two countries, both models deliver a strong underlying message.

Let’s look at the US first.

In the interview with Bloomberg, Trump spoke of reviving a Depression-era legislation called the Glass-Stegall law. It essentially involves splitting banks into two categories – consumer and investment banking. The first is a deposit-taking entity backed by taxpayers and shareholders that primarily provides loans to businesses and consumers. The other banks fall under the category of investment banks and insurers that trade and underwrite securities and create or focus on other complex instruments.

Many experts believe it was the latter – trading and investing – that led to the financial meltdown in 2008, which impacted not only the US but global markets too.

During his election campaign, Trump called for a “21st century” version of the 1933 Glass-Steagall law. The logic behind the law is to prevent tax payer money from flowing into speculative operations from normal banking.

While Trump’s interview momentarily impacted banking stocks, they soon recovered and moved higher on hopes that the sum-of-part valuation will be higher than the current value of these banks.

However, not many are optimistic on Trump’s proposals and feel it would be difficult to implement. The biggest hurdle will be the banks themselves, which are too big to be disturbed. The banking industry has dismissed the idea as not feasible and one that would have a seismic effect on the banking system and impact jobs as well as lending activity.

In India, the rationale for the merger was to prevent the smaller banks from being crushed under the weight of their toxic assets. Banks here have small trading books as compared to the overall size of the bank. Thus, the threat of tax payers and shareholders money moving to riskier capital markets assets is ruled out. In India, lending itself is a risky business with weak laws that prevent recovery from defaulters.

The primary reason that India wants to make big banks and the US wants to break them is the same: preventing the ills of the banking system from spilling over to the economy.

However, the US experience shows us these banks become too big to manage. In fact, most of the top financial and economic roles in US governments have gone to representatives of these banks who ensure their interests are taken care of.

However, It is highly unlikely that the US’ big banks, which fund Wall Street and a substantial portion of global markets, will be allowed to be broken up by the forces that hold the purse strings.

In India, the reality is the exact opposite. Banks are used to meet the government’s social commitments which are at times not financially feasible. Political pressure is used to fund company expansion plans and undertake restructuring that serves little purpose. Since they are nationalised banks, the government cannot be seen failing them.

Both nations need to look at Japan and the historic failure of its big banks. The country has yet to recover from the failure of its big banks at the start of the 1990s. Its economy has shrunk and at 234 percent, the government debt to Gross Domestic Product is the highest in the world. This fact should be enough to deter the Indian government from creating a monster that can take the economy down with it.
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