The new guidelines on private sector banks announced on Monday by the Reserve Bank of India will allow business groups to re-enter commercial banking. The move is important one, in terms of its politics and economics. There are also significant risks in the move.
The bank nationalizations of 1969 and 1979 were based on the premise the private sector was doing a poor job in funding the needs of a developing economy. The nationalizations were an initial success, since the spread of bank branches to even remote hamlets helped raise the national savings rate. Credit became available to small businesses and farmers, as against the earlier trend of business houses using the banks they controlled as in-house financing arms.
The 1969 nationalization was also the big indication that Indira Gandhi was breaking free of the Congress old guard, and beginning her swing to the left. Her move to take over the banking system was defended as recently as two years ago by none other than Congress president Sonia Gandhi and finance minister Pranab Mukherjee, in their own muted signals of a left-ward shift in policy making.
The political control of the banking system also created loads of problems, especially terrible credit monitoring standards. Bad debts weighed down most bank balance sheets by the end of the 1980s, the decade that also saw the infamous loan melas. Banks did not have enough capital to support their rickety loan books. The clean up began soon after the 1991 reforms, following the recommendations of a committee chaired by former RBI governor M. Narasimham.
The public sector banks now account for about three-fourths of the Indian banking market. Yet, for all their achievements, the more than four decades after bank nationalization have left around half of all Indians without even a basic bank account. High lending spreads are a sign of inadequate competition.
Meanwhile, it is obvious that the credit needs of a fast-growing economy cannot be met by the existing set of banks alone, especially since the government banks do not have adequate capital support economic growth.
India surely needs a bigger and more competitive banking sector. At the current juncture, Indian business groups are perhaps the only domestic source of the sort of capital needed to build large and efficient banks. The new guidelines stipulate a minimum capital of Rs 500 crore. More will be needed as the banks build up scale.
The big worry is whether enough will be done to ensure that business groups do not repeat the practices of the 1960s. The new RBI guidelines do have some safety norms, including, for example, exposure limits to the promoting companies, a separate corporate structure with a ”non-operative holding company”, and the requirement that more than half the directors of a new private sector bank should be independent.
Savvy promoters, through the use of off-balance sheet entities or friendly independent directors, can bypass such requirements. So the quality of supervision of the new corporate banks by the RBI will be a key issue in the years ahead.