Merger of banks raises more questions than solutions it offers India’s slowing economy

Consolidation of banks reduces competition, raises fears of cartelisation on interest rates and reduces the hope of privatisation.

A Punjab National Bank branch in Mumbai | Bloomberg

The government has announced merger of public sector banks to create fewer and larger public sector banks. If all goes well, and the merged entities are more efficient, then in the long run tax-payer money will be saved as these banks may not require repeated capital infusion. However, this is a big challenge. Perhaps the move is also an attempt to boost credit in the economy in the immediate context given the slowdown.

Consolidation of public sector banks has been an idea that has been around for many years. Yet, the difficulties in merging banks with different cultures, overlapping branches which would have to be shut in the event of a merger, fears of job losses, different HR practices and other such issues, prevented consolidation from going through. Mergers could reduce duplication, help in consolidating balance sheets, reduce operating costs and increase efficiencies. It would seem that the objective of the consolidation is intended as a structural reform, and not merely a measure to boost credit in the short-term. Hopefully, there are synergies in the businesses of the merging banks and the consolidation will not be as challenging as some may have worried.

The key question is not merely what is good for the banks, but what the implications of bank consolidation are for the larger Indian economy. Will these banks better satisfy the credit needs of the Indian economy? Will they become more profitable and require less tax-payer money as recapitalisation? Will it now be easier to privatise them, if the political will is there? Will this consolidation give India a more competitive banking sector?

One of the biggest issues with Indian banking today is how little the sector supports small firms. Barely 5 per cent of bank credit goes to small firms. Less than 2 per cent of the credit needs of small Indian businesses are satisfied by bank finance. At a time when employment is a huge challenge and the NBFCs or shadow banking system is imploding, the question is, will the credit needs of the millions of potential entrepreneurs in the country be satisfied better after this consolidation?

In the absence of a competitive banking sector, Indian banks, particularly those in the public sector, have often been ‘lazy’ bankers. They have been happy to lend to the government without putting in the effort to look for higher returns by lending to entrepreneurs. In addition, given the fears of vigilance agencies, bankers are risk-averse. Since banks consider small loans to be risky and expensive to give considering the average cost of loan evaluation, policy makers have sought to address the problem by mandating banks to give small loans. Schemes such as Mudra are likely to have to continue with the bigger, consolidated banks.

Fewer pros, more cons

The objective of public sector banking in India is not to make profits but to help the political and economic agenda of the government. Banks have to lend to small borrowers, priority sectors like exports, farm sector, small scale industry or lend to the government. These are mandated through RBI regulations. In addition, banks are known to have lent to infrastructure projects, or to certain groups of companies. This is often at the cost of lending to smaller borrowers.

The lack of competition in Indian banking resulted in a large unbanked population. Banks would often turn away customers with their many forms and onerous KYC requirements. A poor customer walking into a bank branch was usually not welcome. Small accounts do not bring profits, it is costly to keep a zero-balance account alive. It takes effort and time. Again, this problem was sought to be addressed through schemes such as Jan Dhan where most bank accounts opened for the unbanked were with public sector banks. Will this change with the consolidation? There is no reason for it to.

In recent months, the issue most debated is of monetary policy transmission, that banks have not passed on cuts in interest rates to borrowers. The much hoped for increase in demand that could prevent a slowdown did not happen, despite many rate cuts. One reason for this was the lack of competition in Indian banking. Will bank consolidation help bring in more competition and address this issue? Very unlikely. If anything, greater concentration would make it easier for banks to cartelise and offer similar rates, rather than compete for customers. As a consequence, monetary policy transmission is going to remain a challenge.

Finally, consolidation further reduces the hope of the government privatising public sector banks. Larger banks will be harder to sell, their unions bigger and buyers fewer. One hopes that bank consolidation achieves the objective of making public sector banks more efficient, and that this is only a first step in the journey towards giving greater access to banking to both the small borrower and the small depositor.

The author is an economist and a professor at the National Institute of Public Finance and Policy. Views are personal.