Wednesday, December 18, 2013

RBI paper on banking structure

The RBI came out with a discussion paper on banking structure last August. It outlines the RBI's thinking on issues such as bank consolidation, differentiated licensing, continuous authorisation and the role of small banks.

I'm afraid I find myself in disagreement with the RBI's position on these issues. Consolidation of public sector banks is a bad idea because it poses managerial challenges that public sector banks are not equal to. It will result in paralysing large banks as they go through the merger process. If the problem is funding the weaker PSBs, then adopt a two-pronged approach. Accept that government can no longer support the weaker PSBs and let them fund themselves in the market. This, of course, means letting government stakes in these banks fall below 51%. Then, government can focus on strengthening the better PSBs. Consolidation of the strong with the weak will end up weakening the entire PSB system.

Differentiated licenses- giving licenses for banks that cater to niches such as infrastructure or only wholesale or retail banking appears attractive in principle. But it won't work without special regulatory dispensations for such players. That would mean turning the clock back on the idea of a level playing field for all banks, which was the rationale for asking long-term financial institutions to become banks in the first place.

Continuous authorisation of bank licenses seems very reformist. Anybody can apply for a license any time. But you can't have bank licenses available on tap. In banking, you have to limit entry for a variety of reasons. After pausing to take stock, you decide when to let in players, once you have a view on whether there is enough competition or not, whether regulatory capacity is adequate or not and so on. Let us not get carried away by tokenism in one form or another.

As for small banks, these have proved not viable in general. Whether it is regional rural banks or the cooperative banking system, small banks have proved a headache because governance is an issue in these banks. Individual small banks may not pose systemic risk; in the aggregate, they can. Monitoring a host of weakly governed small banks is a big regulatory challenge.

Yes, we need some things to change in Indian banking. But it would be unwise to push through change for change's sake.

More in EPW article on the subject.

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