Don’t expect much from new banks

Earlier this month, the RBI announced the first two ‘in-principle’ approvals of bank licences. Only two out of 25 applicants made the cut. None of the corporate houses qualified. Those who thought a spate of new entrants, including powerful corporate houses, would transform the Indian banking landscape were clearly mistaken. Now that the excitement over who would get licences is out the way, it would be useful to step back and take a hard look at the issue of new licenses. What precisely do we hope to achieve?

In a 2010 discussion paper, the RBI had indicated two objectives: greater competition and inclusion. The need for greater inclusion can hardly be questioned in an economy as under-banked as India. It is the objective of greater competition that needs to be closely examined.

A standard way to measure competition is to look at the concentration ratio in banking, defined as the share of the top five banks in assets. The lower the ratio, the greater is the competition.

India’s concentration ratio of 37 per cent is lower than that in the US (which is around 40 per cent currently). It is also lower than that in the Euro area. In 2012, the concentration ratio in 14 out of 17 economies in the Euro area was over 40 per cent. In the remaining three, it was in the range of 32-37 per cent.

Going by the concentration ratio, it is hard to say that the Indian banking sector lacks competition.

It could be argued that while there is competition, it is not the right sort of competition. More than 70 per cent of assets belong to public sector banks (PSBs). It is often contended that PSBs do not seriously compete with each other. That is why margins in Indian banking have not declined much over two decades of reforms.

On this view, a better measure of competition is not the concentration ratio but a decline in the net interest margin (NIM), the difference between interest income and interest expense as a proportion of total assets. The NIM in Indian banking was 2.8 per cent at the commencement of reforms; even in 2012-13, an exceptionally difficult year for the economy, it was 2.6 per cent. Since the NIM has not declined much, it could point to lack of competition.

It is only the entry of new, private players, the argument goes, that can inject meaningful competition. We need to shrink the role of the public sector and increase that of the private sector. If this is indeed the policy objective of the RBI, it needs to be forthright about it. It would be useful to have a target for the market share of PSBs — say, 60 per cent. Then, new players can be licensed consistent with attaining this objective.

Even this modest objective, it appears, will not be achieved quickly. Two new licences will not take us very far. True, we are told this is not the end of the story. Licences will be available “on tap” hereafter.

There is, however, a crucial sub-text. It may be easier for most players in the financial sector to enter through “differentiated licences” rather than as full-scope banks. The guidelines for differentiated licences are to be made available in the coming months.

The Nachiket Mor committee report on financial inclusion has given us a sense of what “differentiated licensing” is about. The report envisages two kinds of specialised players: a Payments Bank and a Wholesale Bank.

A Payments Bank can take deposits and provide payment services but it cannot make loans. A Wholesale Bank is restricted on the liabilities side: it cannot take small deposits. The main incentives for being a specialised bank are less onerous capital and statutory requirements.

There are serious issues about the viability of a Payments Bank. Even if the concept is accepted by RBI, new players will only offer competition in respect of a small segment of a commercial bank’s repertoire. As for wholesale banks, NBFCs that convert into wholesale banks will get access to cheaper capital but will have to comply with priority sector requirements. It is not clear that the net benefit favours conversion in all cases.

When the RBI framed the guidelines for new licences, it seemed to think that corporate houses with their deep pockets could make a big difference to competition. It is evident that the regulator has since become more wary about a host of concerns about their entry. It is not clear where corporate houses now stand.

Are they free to apply for licences a little later? Or are they too welcome only under “differentiated licensing”. If the latter, it is doubtful that corporate houses will be interested. What they are looking for is the returns of full-scope banks and the punch they pack. Whichever way you look at it, new licences will not change the competitive landscape in the medium term. Significant additions to full-scope banks are unlikely.

Specialised players will not pose meaningful competition. The way to energise Indian banking may well be to breathe life into the existing players — PSBs, regional rural banks and cooperative banks. It should be done and it can be done. For this to happen, however, the ball lies in the government’s court, not in the RBI’s.

The writer is a professor at IIM, Ahmedabad