The recent report of the Internal Working Group (IWG) of the Reserve Bank of India (RBI) that recommended issuances of new bank licences to corporate groups has ignited a debate about who should own and operate banks. While the RBI Governor clarified that the report and its recommendations are suggestions by an internal group and are not (yet) the decisions of the regulator, a more fundamental question worth asking in this context is: Why do we need more banks?
One obvious answer would be that there exist gaps in the current banking system that the new banks would address. The report touches upon some of these issues such as relatively smaller size of Indian banks compared to their global peers, high fragmentation of the sector, and low credit penetration. However it does not offer an explanation of how the new banks would address these issues.
Indian banking system suffers from several major weaknesses. One of them is the share of bank credit to private enterprises and consumers. This share grew sharply from about 30 percent of GDP in 2000 to about 50 percent of GDP in 2013, but has languished at that level since then. In most developed economies this ratio, which reflects credit penetration, is over 100 percent; for some it is 200 percent of GDP or more.
India lags behind even its developing country peers in banking penetration. Large segments of businesses (for example the Micro, Small and Medium Enterprises) and households (the low income, self-employed, etc.) lack adequate access to formal bank credit. Academic research highlights a strong positive correlation between banking penetration and economic growth. In order to experience high and sustainable GDP growth, India must improve its banking penetration.
India also has a highly-fragmented banking system.
Among the large economies, it ranks third (behind the United States and Germany) in the total number of banks. As of March 2019, India had close to 150 scheduled commercial banks (10 public sector banks, 22 private banks, 46 foreign banks, 10 small finance banks, and 54 urban co-operative banks). In addition, we have many regional rural banks, state and district co-operative banks amounting to a large number of entities offer banking in various forms. India’s largest bank has around 23 percent market share and would be considered a medium sized bank by global standards. The share of top five banks is around 45 percent, which is among the lowest in the world.
There are other challenges in Indian banking which have not been mentioned in the IWG report, but many of which have become apparent in the last couple of decades, such as low efficiency and high costs of intermediation, repeated cycle of bad loans, low level of innovation and technology usage, and issues of governance.
The question to ask is: How does adding new banks address any of these challenges?
Banks licensed since 2000 collectively account for less than 5 percent market share. Adding a few new banks is not going to change the fragmented structure of the sector.
More importantly, will these new banks (whether owned by corporate houses or not) serve the segments and geographies left un/under served by the established large banks? It would be a giant leap of faith to believe that the new banks backed by return-seeking private capital will target these segments. If the large established banks are not serving some segments of the economy, it might be more useful to ask why that is the case and address the root cause of the problem.
The banking sector is characterised by significant economies of scale and scope. The large established players in this sector enjoy competitive advantage in most products and segments. When the first batch of new private sector banks arrived in the mid-1990s, they had to compete with the PSU banks that had left many segments unserved given their post-nationalisation, socialistic approach. A good example of this is consumer lending which was essentially started by the private banks around 2000.
These first generation of new private sector banks are now the leaders in banking and hence are the best positioned to expand the coverage and improve the penetration of banking. If these banks are choosing to not do so, then policymakers and regulators must pause to explore the reasons behind this instead of expecting the new entrants to fill up these gaps.
There is, however, one specific area where the new private players could play a role. If there is an effort to privatise PSU banks, then private capital could come in to acquire these banks. This requires a change to the ownership regulation that will permit taking over an existing bank license, and not the issuance of a new one.
The Indian banking sector not only needs adequate capacity, but it needs to become efficient, resilient, inclusive, and innovative in order to be able to support and sustain our economic growth aspirations. Designing the architecture of such a banking sector would require, among other things, critical examination of the functioning of the large, established banks and removal of hurdles, if any, to their expansion into under/unserved segments.
In other words, more banking does not necessarily mean we need more banks. Given the circumstances of Indian banking, issuing new licenses may be tantamount to grafting a tail to wag the dog.