Banking reform must focus on financial inclusion

One gets contradictory messages on banking reform these days. Some talk of consolidation as the need of the hour. This means fewer banks and less competition. Others say net interest margins are too high and we need to drive them down, which would require more competition. And yet others talk of the imperative of financial inclusion- one would imagine this is best done through keeping the existing set of public sector banks with their branch networks instead of opting for consolidation.

Neither consolidation nor lower margins is the need of the hour. India's banking system is not so fragmented as to be unviable and, besides, more concentration means greater systemic risk. If we want to pursue inclusion, we need banks to have reasonable surpluses, so they will need the margins they currently enjoy.

Financial inclusion is what we must focus on. The success of Indian banking in the post-reform period, it is not often realised, is the fruit of the substantial investment in inclusion during the nationalisation period. The branch network created in that period has created the low-cost deposits that form the backbone of Indian banking today and partly account for its financial success in the post-reform period. Inclusion on the asset side helped strengthen agriculture and SMEs and laid the foundation for industry doing well.

There is an opportunity to cash in on inclusion again, thanks partly to the direct cash transfer scheme. This will mean creating millions of new accounts with large cash floats. Whoever can make success of this will getting a hoard of low-cost funds and will also be creating potential borrowers and buyers of financial services a few years down the road.

The issue of licenses for new banks must be linked to financial inclusion targets. With industrial houses, the regulatory issue is not just interconnected lending. Interconnected borrowing is also an issue. A bank set up by an industrial house can easily acquire deposits and salary accounts from other business entities within the house and hence is saved the trouble of having to garner deposits through a large branch network. It is not enough to ask industrial houses to set up branches in under-banked centres. There must be clearly specified quantitative targets for inclusion for each branch. In other words, industrial houses can be allowed into the field, subject to their meeting the basic objective of financial inclusion.

More in my ET column, Banking reform needs focus.