Needed: Consolidation

Bank results in the third quarter point to the need for consolidation in the financial sector.

While some banks have turned in an excellent performance""the State Bank of India's results in particular being an eye-opener""the majority of bank results have been disappointing.

That's partly because banks have transferred their holdings of government securities from the "Available for Sale" category to the "Held to Maturity" segment so as to insulate their portfolios from future depreciation.

But since this transfer has to be effected at market rates, bank bottom lines have been hit. Nevertheless, that hasn't been the only reason for the deterioration in bank results.

There is evidence that most banks have been unable to offset the loss of treasury income with higher income from core banking operations.

It can be argued that this is part and parcel of the cyclical change in the economy; as the demand for bank credit picks up, income from core operations too should increase.

The problem with that argument, however, is that credit growth has already been very high, but this has not translated into huge profits for banks.

The reason for the lower profits, therefore, lies in the intense competition in the banking space. Banking has in many ways become akin to a commodity business.

It's volumes, therefore, that primarily determine profitability, and the route to garnering big volumes is through lower interest rates on your credit, and deep pockets to sustain that strategy.

ICICI Bank's route to pre-eminence in the mortgage market is a prime example of such a strategy. The bigger banks are not only able to attract much of the wholesale business that is available on account of the pick-up in industrial growth but are also best placed to compete on interest rates.

Add to that the fact that the best banks are now targeting small and medium enterprises (SMEs), and you have a difficult environment for the smaller banks""the borrowers whom they can finance are from the riskier set.

To be sure, NPAs have come down, but some banks have been tempted to lower the provisions covering their NPAs in order to show a healthier bottom line.

The government's recent initiatives towards consolidation in banking, therefore, are timely. It's well known, for instance, that one of the reasons for the existence of weak banks in Japan and Taiwan is that their banking systems are so fragmented.

But while there can be no two opinions on the need for consolidation, the manner in which this is to happen needs to be debated. One of the chief benefits of M&A activity lies in its ability to achieve cost efficiencies, whether in technology or in personnel.

Indian public sector banks, however, face severe restrictions on their freedom to reduce personnel after a merger. Further, restrictions on voting rights and on the takeover of public sector banks by private or foreign players limit the scope for M&A activity.

And even if the intention is merely to merge public sector banks, there's much that can be done to allow full autonomy to these institutions.

In short, while consolidation will strengthen the banking system, consolidation without reform will not deliver the optimum results.