People's Democracy

 The Case Against Govt-Directed, Or Elite-Driven,

 Indiscriminate Bank Mergers 

Amiya Kumar Bagchi

BANKS were set up in most countries in order to mobilise savings and allocate them to productive uses. David Hume made one of the classic analyses of the encouragement of thrift and industry through banks and paper credit in his essay Of Money (Hume, 1752). In India, joint stock banks were founded under colonial rule, mostly in order to create a medium through which the government could procure cheap loans, and to provide financial services to British business. But since the 1840s, some Indian entrepreneurs also began founding joint stock banks in order to extend credit to Indian traders who were mostly ignored by the European controlled banks.

SUCCESS OF PUBLIC SECTOR BANKS

After independence, and especially after the nationalisation of the Imperial Bank of India and the subsequent nationalisation of all the major commercial banks, developmental banking came into its own. In the post-nationalisation years, the deposits mobilised and the credit extended by scheduled commercial banks in India have grown at a phenomenal rate. We cite just two figures to illustrate this growth: The aggregate deposits of the scheduled commercial banks grew from Rs 5,906 crore in 1970-71 to Rs 15,04,416 in 2003-04 and the total bank credit outstanding grew from Rs 4,684 crore to Rs 8,40,786 crore between those two years (RBI, 2004).

Indian scheduled commercial banks, along with the cooperative credit societies and the Regional Rural Banks, have penetrated deep into the countryside and have extended credit to farmers, small-scale traders and industrialists, as to big traders and large industrial firms. There was a complaint that the banks had, however, run up large non-performing assets. There have been structural problems causing that phenomenon, such as the collapse of much of the textile sector all over India and of large-scale industry in general in Eastern India from the late 1960s.

The central government turned a blind eye to that structural maladjustment problem. It also refused to nab big or politically favoured defaulters. However, by using some questionable methods, such as shutting down many rural branches and retrenching labour --- policies that were mandated by the monetary authorities --- as well as with the help of some financial support by the government, the bank managements have succeeded in bringing down the NPAs steadily since 2000. The net NPAs of scheduled commercial banks came down from 2.7 per cent of their total assets at the end of March 2000 to 1.9 per cent of their assets at the end of March 2004 (RBI, 2003, 2004).

Further, the profits of the public sector banks (PSBs) have increased at a fast rate during the last few years. The net profit of the PSBs increased by 60.32 per cent between 2001-02 and 2002-03 and by 34.57 per cent between 2002-03 and 2003-04.

WHAT DRIVES THE MERGER DRIVE

I have a feeling that it is the very commercial success of Indian PSBs, the access of a few to this enormous wealth and the greedy attention being paid by foreign financial institutions to rich prizes in India that have come together to prompt the central government to urge the mergers of various sets of PSBs. In order to understand the ‘incentive’ driving the ministry of finance and the various interests pushing it, it is useful to distinguish between the activities of banks as seeding cum cultivating agents and banks as harvesters on the one hand, and the activities of modern banks as over-time seekers of interest from customer activities, and their activities as point-of-time earners of fees (Dymski). Bank mergers, like many other types of liberalisation, directed at increasing the wealth of rich shareholders, has been a tsunami originating in the activities of US financial corporations. Their role has been that of a harvester of fruits of other institutions’ seeding and nurturing activities, and of looking for product lines involving fees for point-of-time services rather than that of durable customer servicing activities. They generally provide usual banking services only to an elite band of up-market customers with whom they have sought to build close relationships.

Bank mergers are advocated by many on grounds of economies of scale and of scope. Before we look into the empirical evidence bearing on that, it should be made clear that there are no obvious economies of scale in banking. Banking is not like petroleum refining so that a three-tenths law of relation between volume and surface area will automatically generate productivity gains as size increases. Banking is also not like ordinary production activities, so that an increase in the size of the market leads always to better division of labour and hence a reduction in cost. Banking is a highly differentiated activity, differentiated by the activities the customers engage in, by the different types and degrees of risk they face and by the strategies open to them to tide over unanticipated shocks. In India and in most other counties, banks come in all shapes and sizes, with different bases of depositors and customers for different types of banks. If US megabanks have succeeded in raising their profitability and hence their shareholder value, which is the altar at which all liberalisers worship, they have done so by excluding 20 per cent of the population of that rich country from banking services (Dymski). Moreover, the gains of US banks have been built on the immensely higher burden of consumer debt in that country --- a debt that has so far been financed by the loans to that country by the rest of the world: in 2004, the US current account deficit has climbed to 630 billion dollars in 2004 (RBI, 2004). There is no other country that can possibly emulate the US banks’ climb to a megasize, even if it were politically desirable to do so.

When advocates of bank mergers, as a general policy move and not as a measure to consolidate the gains of two banks or cure the troubles of one bank by bringing in a different and better management style of another bank, use the argument of economies of scale, they really mean economies of exclusion --- gains made by denying credit to more venturesome customers or customers who need more attention. Even if profitability of banks may increase by such exercises, the real economy may suffer. Innovations are discouraged, production may decline because of shortage of working and fixed capital, and economic growth declines in a context in which jobless growth has been haunting responsible policy planners all over the world.

RELATIONSHIP BANKING

When it comes to servicing small customers, all banking takes the form of relationship banking. The needs of different customers are different and the bank officers dealing with them have to assess both the prospects of the business the prospective borrower is engaged in and the ability of the particular customer to realise the potential of those prospects. Hence it has been considered necessary for a long time in India, going back to the days of British rule in India, to have different types of banks with different kinds of reach over groups of customers and activities. What was permitted to cooperative banks, for example, was not always permitted to scheduled commercial banks serving a different layer of customers.

That a bigger size as such did not make for better banking is clearly indicated by the relative performance of the Bank of Bengal and Bank of Madras, two of the three banks that merged to become the Imperial Bank of India and eventually the State Bank of India. The Bank of Bengal had more than three times the capital base of the Bank of Madras in the late 19th century. But the growth rate of its deposits and of its advances was much slower than that of the Bank of Madras, especially from the 1900s to 1920. More significantly, the Bank of Madras reached out to Indian customers such as rice mills or leather merchants and was prepared to advance loans to apex cooperative banks, whereas the Bank of Bengal confined most of its loans to European customers or big Indian shroffs who acted as the intermediaries between the Presidency Banks and the ordinary Indian moneylenders. The Bank of Bengal simply refused to consider loans to cooperatives as a possible banking option (Bagchi).

ISSUES OF MANAGEMENT

The merger of banks poses also difficult issues of management. Different banks have different cultures of service to customers, and even branches of banks in different regions have different cultures in this respect. For example, the southern region had a higher credit/deposit ratio than the eastern region before the nationalisation of banks in 1969 and that difference has persisted in the post-nationalisation period (Ray). But that ratio has gone down drastically in virtually all regions in India, especially in rural areas, during the period of neo-liberal reforms. If there is any sense among the managers of two banks that there is a strong complementarity between the businesses they conduct and that they and their customers and employees will benefit from regional or product diversification, then they can talk about mergers in a serious way. But that move has to be internally generated and has to be accompanied by a serious exercise setting out all the pros and cons of the move. It is strange that an administration that professes to minimise government interference in economic affairs and increase the autonomy of PSUs should dream up a move without studying the situation on the ground and cavalierly dictate to banks that they must merge or incur official displeasure.

From the evidence that is available in India, there is no indication that bigger size confers greater efficiency as understood by the liberalisers --- that is, a consistently higher level of profitability. Let us take the State Bank group for example. Within that group, the State Bank of India (SBI) is a giant: of the total operating profit of the State Bank group amounting to Rs 14363.52 crore in 2003-04, the SBI accounted for Rs 9,553.46 crore. But over the years from 1998-99 to 2003-04, the net profit as a percentage of total assets of the SBI has been lower than for the group as a whole.

If we move to the 19 nationalised banks, again, it is hard to detect a discernible positive relation between size and profitability over the same years. I have heard on the grapevine of bankers that there is a move to merge the Bank of India and the Union Bank of India. The Union Bank of India has been more profitable than the average nationalised bank during the period 1998-2004. The Bank of India has also been more profitable than the average nationalised banks from 2000-01. Has a study been carried out to find out that the merger will in fact improve profitability and will not do so at the cost of excluding large chunks of their current customers and without drastically retrenching employees?

Suppose that it is claimed that government regulation suppresses scale effects in case of PSBs. Let us look at the performance of ‘new’ private sector banks. (We are ignoring the ‘old’ private sector banks (PRSBs) because they are supposed to have been plagued by some of the same problems as the PSBs, besides being constrained by their size limitation, although in fact, they have on an average performed better than the new PRSBs since 2000-01 in respect of profitability.) Again there seems to be no clear monotonic relation between size and profitability. There is also the stark fact that the average net profit/total assets ratio has been distinctly lower than that of the PSBs in all the years from 1998-99 to 2003-04 (RBI, 2004). The SBI Commercial & International Bank, which was hived off as a private sector bank, has had a particularly lucklustre performance, with widely fluctuating returns between 1998-99 and 2003-04 and a negative average profitability over those years. The policy-makers who advocate disinvestment of government shares as a way of improving the performance of PSBs have to put up a strong defence for their irresponsible advice in view of this accumulating evidence.

PRIVATISERS’ HIDDEN AGENDA

One of the hidden items of agenda of the privatizers is to clean up the balance sheets of the PSBs and make them ready for the kill. Mergers would make them more attractive for the sharks roaming around the global financial seas. Some of the liberalisers may argue that we need to infuse the blood of dynamic foreign banks into the Indian banking industry. One of the first acquisitions of an Indian bank by a foreign bank occurred when the ING Bank of the Netherlands took over the Vysya Bank. The ING Bank has acquired other banks in Latin America and so it is an old hand at the game. The ING Vysya Bank is now classed as an ‘old’ PRSB by the Reserve Bank of India. Its profitability record since 1998-99 has been consistently and considerably worse than that of the average ‘old’ PRSBs, and a fortiori worse than that of the PSBs. So the magic of infusion of foreign capital has done little to improve the performance of the Indian joint stock banks.

However, banks continued to be a favoured area of investment by foreign financial institutions (FIIs) until recently. The government obviously welcomes such investment since it has taken steps recently to disallow some curbs that the RBI had imposed on inflows of foreign hot money. There is no justification for that step. Research at the World Bank itself, not an enemy of global capital movements, has confirmed that not only does free capital movements increase the risks of financial crises but the entry of foreign firms and foreign banks may lead to the misallocation of resources (Agénor, 2001; Clarke, Cull, Martinez Peria and Sánchez, 2002). Small businesses are typically rationed out by foreign firms and only easily monitorable loans made to customers with high-value collaterals find favour with them.

There are also other threats posed by the entry of firms controlled from abroad that any student of Indian banking history should know. In the case of three of the biggest bank failures in Indian history --- namely, the Agra and United Services Bank in the 1860s, Arbuthnot and Co in 1906 and the Alliance Bank of Simla in 1921-22 --- the main factor leading to losses was speculation or unwise investment by the dominant managers abroad, mostly in foreign shares or property. Let us also not forget that the Harshad Mehta scam was primarily instigated by big foreign banks. Indian PSBs lost somewhere around Rs 5,000-6,000 crore in that scam (which also ruined hundreds of small investors) and the government has recovered little of that money. The East Asian financial crisis of 1997-98 was also precipitated by the herd behaviour of foreign fund managers. It is not an accident that the People’s Republic of China and the Taiwan Province of China escaped largely unscathed because they had strictly regulated the entry of foreign funds and banks into their economies (Bagchi).

But, of course, the big foreign banks and their agents are not bothered about the misallocation of resources in a particular country and may be angling precisely for a financial crisis that will allow them to buy up domestic firms at bargain basement prices. According to the Capital Markets Report (2000) of the International Monetary Fund, the presence of foreign owned banks increased dramatically during the 1990s. In Central Europe, the proportion of assets controlled by such banks increased from 8 to 56 per cent between 1994 and 1999; in Argentina, not only did the proportion increase dramatically but after the economic meltdown of 2001, the foreign banks which had earlier bought up Argentine domestic banks were trying to pressurise the Argentine government to bail them out again. Some governments of Mediterranean countries in which these banks were domiciled were playing an active role in these pressure tactics. De-nationalisers wanted national action by a government they had deliberately bankrupted!

LESSONS TO BE LEARNT

Given this national and international background, why is the Indian finance ministry pushing bank mergers (and capital account convertibility as the larger goal)? One argument could be that we need big banks as national champions. But what will they do that a consortium of big PSBs can’t do? Do we want them to bankroll, say, 30 billion dollars take-overs? When they can do that, they will no longer be national champions but simply another multinational bank. What Indian firms might need is loan guarantees for export projects backed by large foreign exchange reserves, and keeping a tight hold of the foreign exchange kitty in the hands of monetary authorities is probably the best way of doing it.

We might learn something about how to do it from the policies of the South Korean government until they gave in to the pressure for capital account convertibility and got caught up in the Asian crisis. Let us not delude ourselves that, with killer whales such as Citibank, Bank of America or Chase roaming the waters of global finance, a mere Indian bank can create or retain a sheltered space for its own hunting: it is much more likely to be swallowed up as a nice mouthful by one of them (Dymski, 1999).

Finally, despite all the talk about prudential regulation lulling neo-liberal policy-makers, in case of massive external shocks or sudden loss of confidence and herd behaviour on the part of FIIs, no country outside the G7 block can protect itself against a balance of payments crisis, a currency crisis, and an economic crisis, if it has been unwise enough to introduce full capital account convertibility (Kaminsky, Reinhart and Vegh, 2003). If the officially initiated move for merging banks is a further step towards full capital account convertibility that it appears to be, then it should be resisted with all the political will of the people caring for the welfare of the many rather than the wealth of the few. But even without that design, the move seems to be based on bad reasoning and poor empirical evidence.

(Amiya Kumar Bagchi is a renowned economist and expert on banking affairs.)