Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

RBI on new bank licences in India

I have a column in today’s Financial Express about the RBI’s discussion paper on new bank licences

Reserve Bank of India (RBI) has begun a very open and transparent process of thinking about new bank licences with a discussion paper that outlines the key issues, presents the pros and cons of the alternatives and also highlights the international experience.

While discussing these important issues, it is necessary to keep two things in mind. First, we must learn the right lessons from the experience of the new bank licences given out in the post-reforms period. Second, the global financial crisis has changed the way we think about bank regulation and competition.

Of the 10 new banks licensed in the first phase, the majority were failures in the broadest sense, but a few became outstanding successes. The viewpoint in the RBI discussion paper is that we must identify the causes of the failures and avoid making the same mistakes when granting new licences.

I am of the completely opposite persuasion. The success of the 1993 experiment was that enough licences were granted to permit a few success stories to emerge, despite a low success rate. Capitalism to me is about liberal experimentation and ruthless selection. What is wonderful about the 1993 experiment is that the failures (although many) were on a small scale and were (with one exception) quite painless, while the successes were outstanding. This makes for an extremely favourable risk-reward ratio.

While handing out new licences, the goal should not be to avoid failures; it should be to maintain the same attractive risk-reward ratio. I believe that this again requires the same approach—granting many licences, allowing the market to weed out failures at an early stage, and giving enough freedom to allow the successes to bloom.

It is impossible to figure out right now what will or will not work in the emerging banking environment. It is very unlikely that a successful bank emerging from the new set of licences will be a clone of, say, HDFC Bank. HDFC Bank and its peers succeeded by identifying what the then existing Indian and foreign banks were not doing well or not doing at all, and then setting out to deliver that with high levels of efficiency. But thanks to their very success, that space has now become overcrowded and hypercompetitive. A new bank starting today will have to find a new space in which to make its mark.

No regulator can predict what that new business model will be. As Hayek once wrote: “Competition is valuable only because, and so far as, its results are unpredictable and on the whole different from those which anyone has, or could have, deliberately aimed at.”

What is important is to keep failures small and manageable, and the way to do that is to allow banks to start small. The RBI discussion paper veers towards allowing only large banks in the belief that this will keep out people who are not serious. This is a mistake that financial regulators around the world appear to make.

I still remember that at the height of the Asian Crisis, one of the few healthy and solvent Indonesian banks was one of their smallest banks (Bank NISP). But the Indonesian central bank’s response (probably encouraged by the IMF) was to impose one of the highest minimum capital requirements in the world. It would have been utterly hilarious were it not so tragic.

Equating money with seriousness is a misconception unique to the financial elite. The rest of the world does not think that a student who has got admission by paying a large donation or capitation fee is a more serious student than the one who came in on the merit list. But financial regulators in India and elsewhere have an abiding belief in the ennobling power of money. Sebi has also been talking about increasing capital requirements for its regulatees.

I believe, on the other hand, that the global financial crisis has indicated that in the world of finance, size is evil in itself. Simon Johnson’s brilliant new book 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown argues for a size limit of “no more than 4% of GDP for all banks and 2% of GDP for investment banks.”

By this standard, which I consider quite reasonable, India has seven banks above the size limit, including one that is almost 20% of GDP (I have taken the bank asset data from the RBI’s Statistical Tables Relating to Banks of India, 2008-09). Of these seven banks, only one is in the private sector, but two other large private banks are growing fast enough to cross the size limit in the next few years.

I believe, therefore, that RBI would grant a large number of new bank licences that will rapidly bring down the concentration in the banking system. India needs a lot of banks that are small enough to fail and fewer that are too big to fail.

Somewhere in the long chain from the keyboard to the printed newspaper what should have been a “should” or a “must” in the beginning of the last paragraph became “would.” Who am I to predict what the RBI would or would not do? I do hope however that my unintended prediction turns out


3 responses to “RBI on new bank licences in India

  1. Bob Kerns August 13, 2010 at 2:16 pm

    Marvelous article.

    A related issue is our fixation on exponential growth. The idea that anything — institution, capital, population — should grow at a fixed percentage is toxic.

    Eventually, such exponential growth will exceed resources, and problems will ensue.

    Capping size is a good approach. There will be consequences, of course. Investors investing in an institution on the basis of growth potential will have to shift either their thinking or their investment as the cap approaches. But a shift toward return and dividends vs growth I think is healthy.

  2. Pingback: ‘Entry of New Banks in the Private Sector’ | Simple Financial Mantras

  3. משכנתא October 22, 2010 at 11:32 pm

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