Should the Indian banking sector approach the issue of its global aspirations

In a closed economy, investments are limited by the savings. A closed economy can invest only what it saves. Trade in capital allows cross border separation of savings and investment. Investments can be higher than savings by borrowings from abroad. As a developing economy offers higher returns to capital than a developed economy, removal of restriction on cross border flows of capital is expected to boost the flow of capital to the developing economies and accelerate their growth. Banks, portfolio investment and foreign direct investments are the possible channels of finance. This is roughly the case for global financial integration.

This is because, gave the low transaction costs in the movement of capital and the high degree of proneness to speculation and herd behavior, free flows of international capital can result in crises such as those witnessed in a host of East Asian economies. Moreover, bank debts are most risky amongst the possible channels of finance, and FDI the least risky and portfolio investments falling somewhere in between.

It can of course be said that FDI with a high requirement of physical and legal infrastructure is the most difficult to attract. The point is that the global aspirations of individual players in developing economies do not necessarily translate into a policy prescription for free cross border flow of capital.
The basic business proposition of banking being trusted, it is possible for banks of small sizes to be very profitable.

The case is cited by Fritz Vogt, one among Germany’s 1400 cooperative banks. Fritz Vogt has enjoyed a healthy growth of 11% on asset size of USD 19 million with no bad debts ever, thanks to the personal touch that banking cannot do without. That is perhaps the reason why evidence in favor of global scale in banking is more fragmented.

In Central Europe where the market economy came into existence only after 1990, the proportion of total bank assets controlled by foreign owned banks is large at around 70%. Nearer home in East Asia, however, foreign share of domestic banking assets is estimated at 9.6%. In India, the share is still lower at less than 7%. Global scale of operations is also no insurance against bank failure or takeover.

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The case of BCCI is well known, and there are any number of instances of takeovers and mergers. This is not to say that global aspirations of the Indian banking sector are illegitimate or unworthy. Rather, the point is that the global scale and operations are not automatic or inevitable.

As far as the banking sector is concerned, global scale and operations are matters, which have to be deliberated within the context of competitive strengths of individual banks. Secondly, global aspiration from the policy viewpoint is important in that the global trends in banking can be taken as the direction which economic policy may increasingly simulate if not completely adopt.

Thirdly, the issue of global aspirations of the Indian banking sector can also be viewed as a benchmarking exercise by the Indian Banking sector to assess and improve their strengths. In this context, I propose sharing my thoughts with you in the following order; First, I shall first trace the major trends in the global banking scenario.

The second step would be kind of reality check on Indian Banking. Lastly, I shall state, who in my view, should the Indian banking sector approach the issue of its global aspirations. What are the major trends observed as far as global banking scenario is concerned?

The first major trend is that of universal banking as a model with emphasis on retail banking. Banks have begun to offer a whole portfolio of services because they aim at maximizing bank’s share of the customer’s wallet. Retail banking is less subject to economic cycles than wholesale or investment banking which explains the emphasis on retail banking within the model of universal banking.

The second trend is that of use of technology in reducing the cost of operations. The process has gone so far ahead that technology is no longer a differentiator between banks. The third trend is towards the emergence of a regulatory model in the form of Basel II which reconciles the market based assessment of risk with the regulatory capital, something which Basel I did not do.

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The expectation is that banks with better risk management would be permitted lower regulatory capital, allowing them more room for growth, as compared to banks with weaker risk management. Lastly, there is a renewed emphasis on effective corporate governance arising as a response to the fiduciary nature of the banking business, the need to raise capital from the markets and stiffer legislation.

Effective corporate governance would correct information asymmetry, increase efficiency and enhance brand image. In the context of these global trends, one may now trace the sources of competitive strengths of the Indian banking sector. There has been sufficient deregulation in the financial sector over the last decade to induce elements of competition in the banking sector.

Secondly, the Indian banking sector has a longer experience of market economies than say the counterparts in Eastern Europe. Thirdly, Indian players also have an international presence. Fourthly, the growth of retail lending, over the last five years or so, if not the quality of the portfolio, mirrors the international trend.

Fifth, India has a large and untapped market. Over 60% of the household still do not have access to banking services.This implies a considerable scope for experimentation, innovation, and expansion which can develop into long term competitive advantages for the sector. Lastly, the public ownership of roughly three fourth of the Indian Banking sector is, for the moment, an effective shield which the banks can use to nurture their competitive advantages. This is as far as the strengths go. One the other hand, one can hardly be complacent, if one looks at Indian banking in terms of cost structure, human resources.

There is certainly an efficient fringe in banking sector, but that fringe is overshadowed by public sector banks which constitute the bulk. In case of public sector banks, operating profit as a percentage of total assets is about 1 percentage point lower than that of foreign banks operating in India.

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In spite of a series of VRS, the wage bill as percentage of total assets in the case of public sector banks is higher by about 1 percentage point as compared to the new private sector banks which show the scope for economies. As regards corporate governance, it is still looked at as a matter of conscience rather than business necessity.

Surely, if Indian banking nurtures global aspirations, it would have to address the in-house issues that I have mentioned.

As regards policy, it is a moot point whether ownership of a large part of the banking sector by the Government, in itself inhibits the forces of competition. As I see it, there is considerable scope for the Government to improve upon its role as an owner by demanding a better return on assets, by strengthening the functioning of the Board of Directors and by holding the top managements accountable so that public ownership satisfies both social objectives and competitive behavior.

This is how one may expect the government policy to unfold in the short turn. In the long run, competitive pressures would only harden and Indian banking can ill afford to derive solace from the Keynesian maxim that in the long run we are all dead. In this sense, agriculture, small and medium enterprises, infrastructure and lastly, the regional and interpersonal skew in income, all offer tremendous scope and opportunity for innovation and productivity growth.

This is not an idle and naive prescription. There are no instances of successful global players who are not successful local players at the same time.

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