Is it better for India to have bigger but fewer banks?

There are reports that India will be going in for another round of consolidation in public sector banking. Reserve Bank of India governor Urjit Patel recently noted at Columbia University that it is better for the country to have fewer but healthier banks.

While the government is considering consolidation of public sector banks, NITI Aayog, a policy think-tank that advises the Indian government, is reportedly working to formulate a roadmap and submit a report by the first week of July.

Theoretically, the key reasons for mergers are economies of scale and scope, revenue enhancement, value maximisation, efficiency gains, cost savings, diversification of customers and assets, and also that large banks help in international recognition. But mergers, in general, are a challenge and have to be carefully designed. They can be successful in similar institutions with a similar culture, but cannot be extensively adopted because it could lead to job cuts, branch closures, and, in some cases, a lowering of the quality and quantity of services. Mere consolidation of weak banks does not produce a healthier institution. It, in fact, can cause great harm to the economy.

The history of bank mergers

The Southeast Asian crisis of 1997 had encouraged consolidation and restructuring of banks in many Asian countries. In the US, there has been consolidation of banks since 1916.

Restructuring of Indian banks through mergers and acquisitions had been recommended by various committees since 1972. Illustratively, the New Bank of India and Punjab National Bank, both PSBs, were merged in 1993. In 1998, the M Narasimham-led committee on banking sector reforms also recommended mergers of PSBs. Consequently, many banks were merged – for instance, the State Bank of Saurashtra and State Bank of Indore with the State Bank of India in 2008 and 2010, respectively.

In this context, the recent consolidation of SBI and all its sister concerns must be viewed as a continuation of the same process. The newly cast and renewed SBI now has a customer base of 370 million, a network of nearly 24,000 bank branches, and 60,000 ATMs. It has been catapulted into the the list of the world’s top 50 banking institutions in terms of assets.

It is necessary that while SBI, India’s largest lender, competes with the very best banks of the world, in terms of size, business, and branch network, it faces some competition from within the country. Further, consolidation is not just about size but also about efficiency and synergy as economies of scale make the bank more productive, profitable, and competitive. There is evidence to show that large PSBs are more efficient and perform better than small PSBs. Hence, the need for their consolidation.

Not just mergers

If consolidation of banks is being pursued to strengthen the PSBs and resolve the issue of rising non-performing assets and constant need for recapitalisation, then other alternatives like privatising loss-making PSBs and rewarding profitable ones also must be explored. Many nations, including those from the erstwhile eastern bloc countries, have privatised their nationalised banks.

This implies that the 60-year-old policy of social control in India would need to be reviewed. As the Planning Commission was a vestige of the socialist era, so is social banking. It is time to see whether PSBs are really required to serve social banking in our country and, if so, at what cost. Privatising a few loss-making PSBs will ensure that market discipline forces them to rectify their strategy, and this will have a ripple effect on other PSBs.

In India, since 1991, PSBs have been tapping the capital market but have not been privatised. Privatisation is not going to be easy as it would involve building consensus among various stakeholders, including unions and parliamentarians. The decision to privatise inefficient PSBs, consistently delivering negative returns and seeking increasing recapitalisation, would require a wide debate.

Conservative approach

In the period of uncertainty that the country is transitioning through, it may be necessary to adopt a conservative approach. India has only recently emerged, not totally unscathed, from the most unique and disruptive experiment of demonetisation.

The money supply has yet not been restored to its original pre-November 2016 level. Even now, in major metropolitan cities like Bengaluru, a number of ATMs are still cashless. While the economy is still recovering, business are gearing up to adopt the goods and services tax . The terms and conditions of GST are still being considered and the government is trying to make it business friendly for wider acceptability. Still the task is herculean, given the GST’s complexity with different rates in various sectors and exemptions. The implementation of GST could also be disruptive in initial stages.

The business community’s nervousness is also reflected in regular discussions in trade associations and extensive rush of discount sales across the country, including e-commerce platforms. The global experience, empirical in nature, also indicates that GST could be both inflationary and disruptive in the initial phases.

In such a challenging environment, delaying the consolidation of commercial banks in India would be helpful. The need is to sequence the reforms in a manner that the business community and general society do not feel the disruption in economic activity and credibility of the Indian banking system is not eroded.

After all, banking lubricates the engine of growth and development.

This article first appeared on Quartz.