India's timid banking renaissance

India is slowly opening up its stable but tightly regulated banking sector. But with inefficiencies galore, it would be better served to turbo-charge the process.

Indian banking is all aflutter. Last month the country’s central bank finally unveiled the rules under which it plans to hand out new bank licences for the first time in a decade.

Dozens of companies, including many of those led by India’s most celebrated corporate elite, are now busying themselves with applications.

The process ought to bring about a welcome shake-up of India’s banking industry, introducing fresh blood into a sector struggling to provide the financing its nation needs for future decades of rapid growth.

Unfortunately this already looks unlikely, an especially disappointing outcome given the fact that the case for a vibrant new generation of private sector banks looks so strong.

India’s is a curious, hybrid system, in which three-quarters of the market remains in state hands, the legacy of former prime minister Indira Gandhi’s decision to nationalise all banks in the 1970s.

Newer private operators make up about a fifth, with the balance taken up by a sliver of foreign groups whose operations are hamstrung by strict limits on the number of branches they may open.

In some ways this lopsided sector has performed well; with banks that are cautiously regulated, well capitalised and which made it through the global financial crisis with little drama.

However, elsewhere signs of trouble are growing. The public banks are a particular worry, suffering from uneven management, low productivity and rising bad debts.

The sector overall is distorted by regulations too, not least the requirement that all banks must park about a quarter of deposits in government bonds – a handy way to fund a rising fiscal deficit, but hardly an efficient use of capital.

More importantly, India’s banks lack the scale necessary to support the expansion of the country’s largest businesses, especially given government targets to invest about $1 trillion in infrastructure by 2017, roughly half through the private sector.

Here the comparison with China is stark: India’s commercial banking system has assets of about $1.5 trillion, according to the Reserve Bank of India, less than those held by any one of the four largest Chinese banks.

Not all of these issues will be solved simply by creating a few new banks, of course, but such a process could play a positive role nonetheless.

India’s private banks might have limited market share, but most are well managed and profitable, including the two largest, ICICI and HDFC Bank, which won licences in the early 1990s.

They also suffer far fewer bad debts than their public sector competitors, and have proved more innovative in introducing new products and technology – part of the reason it seems sensible to create more in the same vein.

Indeed, the problem with the central bank’s approach is not that it is mistaken to issue new licences, but that it is likely to issue too few, and to do so too slowly.

Speed is hardly the regulator’s forte, but even so its plans to hand out just four or five licences, and then perhaps not even until later next year, seem excessively cautious. The few winners will then take a year to set up, possibly three more to break even, and then a decade again to build up any real scale. It hardly amounts to a vigorous shake-up.

More to the point, it isn’t obvious that any limit on the number of new licences is needed at all. As C. Rangarajan, head of the economic advisory council to India’s prime minister, wrote recently: “There should be no bar on the entry of new banks; a closed system can only become oligopolistic.”

Instead, the central bank could move towards a set-up in which any business that meets its already stringent criteria could expect to win a licence, gradually opening the sector up to new competition.

And what of scale? As Chanda Kochhar, ICICI chief executive, noted in an interview with the Financial Times, India’s banks will grow much larger over the coming decades, in step with its expanding economy. However, it would be helpful if they could do so more quickly still, and in particular if the government relaxed restrictions that stop private banks – be they existing or new entrants – taking over some of the worst-performing public sector operators.

None of this would amount to a revolution in Indian banking. But, creating more banks in the mould of the country’s best, and letting them grow more quickly, would be a solid step in the right direction.

Copyright The Financial Times Limited 2013

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