Everybody has been asking when the big fallout in the Indian banking systemis coming and hopefully this is going to usher in a spate of deals as we gointo year 2000. Looking at our banking system, it is so full of problemsthat it is difficult to say which of them are the more serious ones. I wouldhowever venture to say that while some problems are of a temporary nature,the looming threat from the burgeoning mutual fund industry is perhaps themost dangerous.

In the last two years the mutual fund industry has really made impressivestrides in India. After the tax incentives given by the Government formutual fund dividends, the growth in the funds under management has beendistinctly higher than the rise in the bank deposits. It is worthwhile to doa comparative analysis of the two industries at this point in time. When itcomes to cost of funds, the banks still do have an advantage but on the flipside the investor - or the depositor - gets a higher return on his moneyfrom the mutual fund. So in the market place if an income fund and a bankmanager are competing for peoples savings, the mutual fund is a much betteroption, with the tax benefits thrown in.

On the return on asset side the banks probably have a slight advantage. Forthem it is a weighted average of the returns from loans, investments andcash reserves. This is somewhat variable and depends on the demand for moneyin the system. The mutual funds in a way invest in only rated paper orGovernment securities and hence have a more predictable but perhaps slightlyless return.

So far it would appear as if the banking companies do have a slightly betternet spread on funds. But this gets totally wiped out when you make acomparison of costs. The banks have a huge cost base in India and expensescan be as high as three or four per cent. On the other hand mutual funds arevery tightly managed and very low on cost. This great advantage translatesinto a much better return for the investor.

Banks do have a couple of aces up their sleeve. Banks are banks and peopleinstinctively feel safer investing in them. Further, they have depositguarantees and small depositors are sure that their money in their bank is ahundred per cent safe. This is one thing that they would like to play on.The income funds would try to counter this by saying that their assets areexcellent and hence investing in them is as safe as investing in banks.However, safety wise banks still have a clear advantage.

Secondly, there are still many things which only banks can do. To start withyou can write cheques to pay your bills though as things are moving it maynot be very long before you can write cheques of your mutual fund accounttoo. You need banks to send remittances, to establish letters of credit, toprovide guarantees to transfer funds to different parts of the world etc.There is a whole family of business called non-fund-based business whichonly banks can do. But compared to this, however, banks have the problems ofbad loans. Bad loans can totally wipe profits off a bank balance sheet.

Provisions for bad loans in India which were hitherto rather lax are nowmuch more strict and banks are forced to report more conservative profits.What does all this add up to? I believe it is a serious situation for banks.Their valuable depositors are fast moving to mutual funds. Their bestclients are entering the capital market directly and raising money atdirt-cheap rates. The only solution for banks - and this is how it hasworked in US - is to really become transaction managers. That means issuecredit cards, open ATMs and do a hundred other things rather than lendmoney. It is a strange thing but the only way banks can survive is if theydo something else apart from banking. Remember the old gramophone record.

The author is a Delhi-based merchant banker based and his email addressis pnvijay@vsnl.com