India needs hundreds more banks; their ownership is not the main point

While deciding on policy regarding ownership of banks, it would be good to remember that banking is a commercial activity and therefore can't have zero risk

Does India have too many banks? Does it have too few? How many banks must a country have anyway?

These are the real issues that the RBI needs to discuss and not merely who owns a bank. But then we are Indians, prone to be distracted very easily.

Let’s just start with two crucial numbers. These should help focus minds. One, the credit-GDP ratio in India is a miserable 50 percent. In countries with comparable economies the ratio is over 200 percent. Two, this ratio is a function of the number of banks a country has. Thus, at last count the US and China both had over 4,000. So not only is rural India under-banked, the entire Indian economy is under-banked.

As the Raghuram Rajan Committee on the financial sector pointed out in 2008 we need many hundreds of more banks. But that was 12 years ago. Today I’d say we need to at least a 1,000 more banks. Yes, don’t faint, a 1,000, up only 400 from when the economy was a tenth of what it is now.

Without that many banks the economy will never get the lubrication it needs for achieving the fancy rates of GDP growth our governments like to talk about. Nor will the economy get properly formalised. Money will flow in it but from the informal sector with all the inherent problems that this creates and causes.

Two big questions

This raises two questions. How big must these new banks be and who should own them.

The Raghuram Rajan Committee gave the answers to both. It said we must have a few hundred small banks and no bank should be owned by an industrial house unless there were strong safeguards against related-party transactions.

This was absolutely right, again for two reasons. One, before nationalisation in 1969 there were over 600 banks and lots of them were very small banks, specialising in localised lending against commodities. At that time many banks were also owned by large industrial houses which were simply accessing depositors’ money for their own use. The risk to depositors was thus extremely high but that’s not why Indira Gandhi nationalised them.

Union Finance Minister Nirmala Sitharaman during a press conference after cabinet decisions in New Delhi on Wednesday.

Mr Rajan’s Committee stopped short of saying who -- if not the industrial houses and the government -- should own the new banks. We still don’t know who should because it is an extremely difficult question to answer when a society and its government want zero risk in commercial activity.

Zero risk nonsense

And this raises a political question that feeds into economic practice: How do we get rid of the political aversion to risk?

The short answer is that, in a highly contested and contestable electoral market for votes, we can’t get rid of it except very gradually, if at all. For example, the FDIL bill sought to shift risk from taxpayers to depositors but was resisted with extreme hostility. It’s as good as dead now.

Indeed, this is exactly what the stiff resistance to the agriculture reform laws is showing. Farmers want an assured minimum price in an activity that, like banking, is inherently risky.

Public sector no different

The first thing we need to acknowledge is that the Congress-style phone banking -- huge loans given after a phone call from the minister -- was also very risky. This is what the listing of NPAs has shown. Almost all of these loans are from public sector banks. That tells us that ownership is no guarantee against fleecing the depositor.

The only difference between the way the PSBs have been run by politicians and the way some private banks owned by industrial houses were run before nationalisation is that in the latter case there was no taxpayer to come to the rescue.

Last but not least, here’s the link to a brand new research paper about regulatory forbearance that is worth reading in this context.

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