Ever since Reserve Bank of India (RBI) unveiled the new roadmap for the entry of foreign banks starting from April 2009, there has been much discussion about consolidation of Indian banks. Unless the stance of RBI is seriously redefined after appraising developments between 2005 and 2009, foreign banks will be allowed grow in the country with very minimal intervention.
As an entry strategy, most foreign banks have followed the route of acquisition in those markets, particularly in the Asian region, whenever restrictions were eased. Assuming that foreign banks will follow the same strategy in India, the fear is that given their money power and competitive strengths, they can easily acquire Indian banks. In this context, it has been proposed, even by policymakers, that Indian banks have to consolidate?the underlying assumption being that foreign banks are not capable of buying big banks!
The banking system across the globe is increasingly driven by financial innovation, facilitated by advancements in information & communications technology that has brought about changes even in the choice of instruments. Undoubtedly they have better competitive advantages over Indian banks in terms of cost leadership and product differentiation. Indian banks can minimise their cost of operation if they enhance economies of scale, and the route suggested is consolidation. Such a proposal assumes that consolidation is the only key to attain economies of scale, as if quality of banking services is immaterial.
Were we to ignore these assumptions, what about the state of competition that may emerge subsequent to consolidation? This needs to be viewed at two levels. Given the fact that banks are the conduits of monetary policy, can the country afford to have only four or five major banks? When a few banks consolidate, the number of players is reduced, which consequently brings down competition in the banking system. This is likely to result in pricing and cost inefficiencies.
Informed views suggest that many bankers lend even below the prime-lending rate, and in case of export credit, some banks provide credit at lower rate than the stipulated rate, much to the benefit of borrowers. This is a direct outcome of competition in the present banking system. This has brought about cost efficiency in the banking system. Consolidation of banks can reduce such benefits of competition.
Although many Indian banks have a regional orientation, some leading development economists have found that banks tend to be mostly urban-centric and have not served rural areas adequately. This raises several concerns with respect to financial inclusion. After consolidation, banks become big, and these banks will be driven by the sole criterion of maximising profit by minimising cost. Many rural branches are likely to be closed under the pretext of profitability.
The issue of bank consolidation reminds one of the Marshall Dilemma, as found in economic textbooks. While consolidation enables economies of scale and thereby contributes to cost reduction, it also gives rise to the emergence of a near imperfect market structure that is capable of undermining competition, much to the loss of customers. Consolidation will not improve allocative efficiency; for, a certain section of society will become worse off if banks consolidate. Consolidation of banks is, thus, unlikely to augment the welfare of society as a whole. If the cause of fear is the entry strategy of foreign banks, then let RBI allow foreign banks grow, but in the organic way. Let competition prevail.
The writer teaches at Icfai Business School, Bangalore