Explained: What will India’s bank mergers fix?

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Published: September 11, 2019 1:53:29 AM

The issues that the recent merger of PSBs address are only the tip of the iceberg of the financial sector reform that India desperately needs.

Will the costs of the mergers be worthwhile? It is hard to be sureWill the costs of the mergers be worthwhile? It is hard to be sure

The planned mergers of several of India’s public sector banks represent another bold move by the current government. It is hard to imagine previous governments acting so dramatically, although there have been previous bank mergers, as the problem of non-performing bank loans has emerged over the past few years. The gravity of the situation certainly calls for decisive steps, although recognising bad loans, and cleaning up balance sheets directly is what is truly needed.

Why merge banks? For financial institutions, combining portfolios can provide additional risk diversification, and that is part of the motivation. India’s banks are relatively small by international standards, so mergers could also provide economies of scale, and make the merged banks more competitive. More importantly, combining weak banks with stronger ones (in terms of balance sheets) can reduce the risk that the weaker ones go under, although one has to be careful that the weak ones do not drag down the strong. Presumably, the mergers that were chosen have this rationale, and the underlying analysis has been performed to support the decisions made.

An additional potential benefit is that, if the stronger banks in the mergers were better-managed than the weaker ones, they could transfer their better management practices to the acquired entities, leading to banks that are better-run. Whether this turns out to be true has to be seen, and there are genuine concerns that the “acquiring” banks will find their management expertise, and attention, stretched beyond what they can handle, especially in a situation where they are already dealing with the problems created by non-performing loans. Potentially, this difficulty can be handled by hiring experts specifically to implement the mergers, which will require combining all kinds of information technology systems, as well as organisational structures. Both, software and people, are likely to present challenges, and affected bank employees are already expressing unhappiness with the mergers. All of this is manageable, provided that adequate attention and resources are devoted to seeing through all the detailed implementation steps required.

Will the costs of the mergers be worthwhile? It is hard to be sure. There is another aspect of the situation that may reduce the net benefits of this entire exercise. The problem is that public sector enterprises in India are not just inefficiently run, on average (which may not be improved simply by merging several organisations into one—recall the merger of Air India and Indian Airlines), but they are also subject to exploitation by politicians. This is especially true for banks, which can directly dole out money to those who are politically favoured. Nothing in the process, and outcomes of merging public sector banks solves, or even reduces, this problem.

The real solution is to have a system where political distortions are less likely to occur, and that means relying more on private sector enterprises—though they, too, may be subject to political pressures, and even extortion. Currently, private sector banks in India are less affected by non-preforming loan problems. Some of this difference may be because they can cherry-pick customers, and choose lending strategies that are driven more by profit maximisation, without social goals being factored in. But, in India, even private sector banks are required to make some loans based on social goals. And, private sector banks can also be looted by those with connections—political, familial or other. But, on the whole, it does seem that private banks in India have been better-run, and performed better than their public sector counterparts.

The implication is that allowing existing private sector banks to expand, or new ones to enter, and reducing the government’s stakes in public sector banks may be necessary steps, irrespective of the current pursuit of mergers. In that case, one might question the wisdom of expending resources on the mergers, rather than moving towards greater privatisation. Again, it is difficult to make blanket judgements, and one will have to see how the implementation, or mergers, proceeds. But, one should constantly stress the need to fix the underlying problem of non-performing loans, as well as the organisational weaknesses that contributed to the loan problem in the first place.

Another, deeper structural issue that also needs attention is the limits of traditional banking, especially in the age of digitisation. Other types of financial intermediaries may be more suitable for many kinds of financing of investment. The problems of NBFCs in India illustrate the urgency of structural reforms that are needed there as well. There is also the potential to use digital platforms for intermediating savings, and investment for various needs, and the government and RBI should both be working to accelerate innovations in financial intermediation, while making sure that regulation is well-designed, and properly implemented to reduce moral hazard problems.

While the bank mergers have attracted considerable attention, and will continue to be analysed, the issues they are addressing are only the tip of the iceberg of financial sector reform that India desperately needs. This aspect of economic reform deserves to receive more attention from the media, and from academic economists, as well as from policy makers. If the bank mergers trigger this increased attention, that will be a welcome spillover.

(The author is Professor of Economics UC, Santa Cruz. Views are personal)

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