Bank on size

The moratorium imposed on the United Western Bank by the Reserve Bank of India (RBI) last week, and the subsequent efforts to find a buyer who will be able to absorb the impact of its failure, highlights many things that are both right and wrong with the banking environment. On the positive side, the decision to shut down the bank as soon as some key financial indicators touched the danger mark indicates a welcome acceptance of the reality that, in a market economy, banks will fail now and then, regardless of how good the norms of prudential regulation and their enforcement are. In the US, for instance, banks routinely go belly up; the concern of regulators, then, is to ensure that their liabilities are met as quickly and effectively as possible, using deposit insurance cover or whatever other means they have at their disposal. The RBI has shown similar alacrity in recent instances of failure, notably the Global Trust Bank some three years ago, which was eventually taken over by the Oriental Bank of Commerce. The temporary discomfort of depositors is a small price to pay to avoid permanent and irrecoverable losses of the bank's funds by letting it carry on business. They will, undoubtedly, get their money back and sooner rather than later.

However, the episode also points to weaknesses in the system, which the policy regime may well be aiding and abetting. It is clear by now that the probability of failure is inversely correlated with the size of the bank. Smaller banks fail far more frequently than large ones. The policy response to this should be a relatively high degree of permissiveness towards bank acquisitions, facilitating the absorption of small banks with good business models but weak finances and management, by large players who can realise their potential. Unfortunately, the road map laid out by the RBI last year deters this by imposing a cap on the equity holdings of large banks in smaller ones. ICICI Bank, a leading contender to take over the United Western Bank, did acquire strategic stakes in a number of small banks in South India but was constrained by the regime to either absorb them completely or divest its holdings. Had this not been the case, a larger bank could well have taken over this smaller one before it hit the skids. In fact, the strength of larger banks has been emphasised by the recently published second Tarapore Committee report, which sees them as being better able to handle the risks associated with full capital convertibility.

The other issue which the episode highlights is the rather inefficient process of bank supervision itself. News reports indicate that the United Western Bank had been in the RBI's sights from 2001 onwards. There is a dilemma here, of course. If the supervisor were to act in haste, it would have precipitated a run on the bank even when the financial indicators did not warrant it. But, as appears to be the case here, if it took five years for the crisis to precipitate, the question must surely be asked: could less disruptive actions, such as a takeover, have been initiated sooner? Why let things slide to the point of having to make a distress sale, when better value could have been realised for the bank's undoubted assets a few months ago?