The Hindu Business Line : Indian banks should be more competitive

Competition among banks should lead to improved customer satisfaction which, to a large extent, is determined by the costs of services they render. Competition should be growth-enhancing in that it should help reduce the servicing costs of banks and boost entrepreneurial innovation. The institutional mechanisms associated with prudential regulatory structures have to actively promote competition even while paying attention to banking stability, points out A. Vasudevan.

ASK any senior banker whether Indian banks face competition. They would answer in the positive. They would elaborate on the efforts they have to put in to garner resources and to expend them through loans and investments. Is this really true? Competition in banking is limited largely to the urban and metropolitan areas. What one witnesses as competition is limited to a few functional areas, such as the setting up a large number of cash machines, issuance of debit/credit cards with larger emphasis on debit cards, retail banking or personal banking, fee-based services and business on account of mutual funds. One hardly sees any competition in the rural areas.

Concentration of business in a few functional areas is guided by the larger level of profits they generate than other functional areas with relatively low cost incurrence. Profits are also high because banks have been paying low interest to their depositors and maintaining the wedge between the rate they get on the assets they generate and the rate they pay their customers. This has been rendered possible because of what might be described as a `complex monopoly' situation being perpetrated by the large banks.

The first moves that large banks such as State Bank of India and ICICI Bank make in respect of deposit rates are taken by the rest of the banking system as signals about the interest rate regime. A soft regime, given the wedge, would mean that deposit rates should be either maintained or increased only by a very mild margin. The wedge, by implication, becomes critical and is defended on the ground that banks have to incur large costs on account of modernisation and new technology adaptations. Once technology costs are stabilised, it is claimed, the wedge would be amenable to reduction.

The reality, however, lies somewhere else. Banks are said to be `special' in India as elsewhere in the world. They need to show large profits — the one indicator of sound growth of banks. Given that public sector banks' deposit and loan business is predominant, at almost three-fourths of the country's total commercial banking business, public sector bank profits make up a substantial proportion of total profits of the banking system.

The contribution of profits to the public exchequer is thus large. And this enables the Finance Ministry to pursue the development agenda.

Profits of private sector banks are ploughed back or are used for diversification. In either case, there is what might be called `social' contribution. The banking system's `social' contribution is said to override the concern for protecting the consumer from the detrimental effects of competition among banks. Large profits also imply that bank failures do not exist. Bank failures, it is well known, could be catastrophic and inflict enormous costs that would have to be written off ultimately by the state.

To ensure that competition does not impinge on the profitability of banks, the authorities put in place prudential regulations. To put it differently, prudential regulations are undertaken to promote competition, not impede it, helping, in the process, to eliminate the costs of banking failures.

This does not mean there would be no weak banks, weakness being viewed from the point of view of prudential norms. Even weak banks make profits, albeit small in quantum. But if banks should make substantial, if not excess profits, it is said that weak banks should be transformed into bigger banks through mergers with relatively big and strong banks. Such a solution, it is suggested, would be in line with one of the characteristics of banking, namely increasing returns to scale.

The discussion on bank mergers is, however, conducted on slightly altered grounds. It is understandable that mergers eliminate possible threats to the banking system and bring about improved efficiencies in the form of increased profits. There is often a hint, obliquely rendered, that the number of banks in India is at present rather large and should be reduced to a more manageable level. However, there is nothing in either the theoretical or the empirical literature to endorse such a suggestion.

The number of banks in India and the degree of concentration of their business are not sufficient indicators of contestability in the credit market. Competition should lead to improved customer satisfaction which, to a large extent, is determined by the costs of services that banks render.

We do not have credible customer satisfaction surveys, but from the anecdotal information one gathers, it appears that banks charge much higher costs for their services now than before. The charges are often perceived to be excessive or exorbitant in the case of new private sector and foreign banks. No wonder income other than interest income — in particular, the fee-based income — is very high in recent years.

Why is it that commercial banks are less enthusiastic about extending their services into areas where `social' contribution issues come to the fore? One suspects this is because of high costs that banks would have to bear without being able to pass them on to their customers. For example, banking services for small and medium enterprises (SMEs) will mean large costs including those associated with collection of information required to comply with the know your customer (KYC) norms.

Information gathering costs are only one side of the problem. There must also be processing costs and other costs associated with operational risks. Otherwise, how does one explain the fact that the total outstanding loans to agriculture by both public and private sector banks in 2004-05 (at Rs 1,22,370 crore) was less than the outstanding loans for housing (at Rs 1,34,653 crore) in absolute amounts? Outstanding loans to small-scale industries (at Rs 76,114 crore) in 2004-05 were lower, in absolute terms, to the outstanding `other personal loans' (at Rs 1,20,120 crore).

The data on yet another lucrative business, namely cards, is scanty from anecdotal information on the subject suggests that in terms of effective use, the number is much less than the number of cards issued. There are many instances of issue of multiple cards to a single customer with charges perceived to be high by most customers. The disconnect between those who look after the card business and the main accounts with which the cards are tied is substantial.

Banks have still a long way to go to be truly special. While asymmetry of information that characterises banking is often a discouragement, it is necessary for banks to pay greater attention to lending for production and for innovation by others. It is widely recognised that in less advanced economies, growth is largely a function of factor accumulation and technology imitation but this does not mean that there could be no frontier innovation.

Competition should be growth-enhancing in that it should help reduce the servicing costs of banks and boost entrepreneurial innovation. It is for this reason that banks will have to lend to many credible start-ups and make gains or reap the rents thereof.

The institutional mechanisms associated with prudential regulatory structures would have to improve competition even while paying attention to banking stability. This is enormous work and cannot wait to be undertaken by the Competition Commission, which is yet to effectively begin functioning.

(The author, a former Executive Director of the Reserve Bank of India, can be contacted at asurivasudevan@hotmail.com)