Tamal Bandyopadhyay, Deputy managing editor, Mint

She hadn’t yet qualified for the course and didn’t know whether she would make it. She had done reasonably well at the Graduate Management Admission Test (GMAT) and after choosing ISB, dropped in at the local branch of a public sector bank in the western Mumbai suburb where she lives. The branch manager gave her a patient hearing and promised to finance her expenses up to 8 lakh if her mother was willing to provide adequate collateral. She would also have to give an undertaking promising to return the money after she gets her first job.

Towards the end of the dream sequence, the six bank managers are chasing her—one of them waving a 21 lakh cheque at her (the way Amitabh Bachchan does on Kaun Banega Crorepati), another willing to offer an additional 2 lakh to take care of field trips and incidental expenses and the third willing to cover four round trips by air during the year between Mumbai and Hyderabad.

For Sapna herself, the dream turns into nightmare when the bankers overtake her and push her into a coffee-shop and force her into signing a loan deal. But for many Indians, a dream is what it remains.

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Let’s look at some numbers. India has about 89,000 bank branches, 55,000 automated teller machines (ATMs) and half a million point of sale (PoS) terminals at thousands of merchant establishments, besides 850 million mobile phones that can also, to a limited extent, offer banking transactions in the world’s 10th largest economy.

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That can’t conceal another telling statistic—half of India’s 1.2 billion people don’t have access to banking services.

In 2008, when many banks and financial institutions in the US and Europe were in deep trouble as the world witnessed an unprecedented credit crisis in the wake of the collapse of Lehman Brothers Holdings Inc. and needed to be recapitalized by their governments, Indian banks were hale and hearty. They were profitable, well capitalized and there was no worry on the quality of their assets.

While the banking regulator played a key role in ring-fencing the system from the impact of the North Atlantic crisis, credit should be given to the Indian government for infusing competition in the sector. This was done by allowing two new sets of banks to set up shop, first in 1993-94 and later in 2003-04, besides paring government stakes in public sector banks and listing them. These helped change the profile of the staid public sector banks that account for 70% of the industry as they have to meet investor expectations. Unless customers are cared for, business and profitability will not grow and investors will not be happy.

Incomplete story

This has been the story so far—but it’s an incomplete one even though the banks have been moving in the right direction. Three key developments will determine the future of banking in India: freeing of savings bank accounts, allowing larger play to foreign banks and the entry of a new set of private banks.

While rates have been freed on loans as well as deposits, the savings bank rate is the only one that’s mandated. RBI wants to free it, but banks have been opposing this as they fear that a rate war will erupt and their cost of money will go up dramatically.

Currently, they pay 4% on savings accounts. For some banks the share of these accounts in overall deposits is as much as 25% or more.

A mandated savings bank rate is an anachronism in the Indian financial system. If RBI indeed frees it, the next round of battle in Indian banking will be fought outside the metros, in semi-urban and rural areas where depositors mostly keep their money in savings accounts.

Also, it will be a battle for liabilities (read deposits). Traditionally, Indian banks have fought to grow their loan book.

RBI also plans to “incentivize" foreign banks and treat them almost on a par with local banks if they agree to go for local incorporation and become subsidiaries of foreign parents. Moving from being a branch of a foreign parent to local incorporation has tax implications and once this is sorted out most banks are expected to float Indian subsidiaries.

The market share of foreign banks in India has remained unchanged for decades—at around 7.5%—but this will change and they will play a much larger role once RBI finalizes norms for local incorporation.

RBI may allow them to raise rupee resources in the form of non-equity capital and extend a less restrictive branch expansion policy if they choose to operate in semi-urban areas. Currently, there are 36 foreign banks in India and collectively they have about 315 branches.

Under a 1997 World Trade Organization (WTO) agreement, total assets of foreign banks in India cannot exceed 15% of the banking system.

But RBI is changing the limit in terms of capital and reserves of banks. Once they are locally incorporated, when the capital and reserves of foreign banks in India exceed 25% of capital of the banking system, the regulator will put restrictions on the further entry of new banks and branch expansion besides making its prior approval mandatory for capital infusion.

Under the WTO agreement, RBI needs to issue 12 new branch licences to foreign banks every year, including those given to new entrants and existing players. The Indian regulator has allowed foreign banks to open more branches, going beyond its commitment, but not as many as the foreign banks want. This may change and they will have a greater presence, benefiting corporations as well as individuals by bringing in new products and delivering them fast.

Finally, 42 years after nationalizing the nation’s major banks, India is readying to allow industrial houses to return to the banking space, something many countries across the globe are still wary of as smart corporations are capable of using money to their advantage and deny funds to competition.

It’s fairly well known that RBI was not too keen to have more banks in the system when finance minister Pranab Mukherjee announced the entry of private firms into banking in his February 2010 budget speech. Mukherjee’s drive for more banks stems from the lack of financial inclusion.

In 1993, when India first opened up the banking sector to private firms, the objective was to infuse competition. To a large extent that has been fulfilled, as the so-called new generation private banks such as ICICI Bank Ltd, HDFC Bank Ltd and Axis Bank Ltd have forced the public sector banks to become more nimble-footed. But these banks have not been able to spread banking across the country as their focus has all along been on urban India.

This time around, the focus is on spreading banking services across the nation. If half the population does not have access to banking, simple arithmetic suggests India needs to double the number of banks. It’s not known how many banks will be allowed and what they will do to spread services across India, but clearly the existing ones don’t have the scale.

The August issue of The Banker magazine, a Financial Times publication, illustrates the dramatic transfer of economic power from the West to the East in the rankings of the top 1,000 banks.

There are three Chinese banks in the top 10, up from one last year, while the number of the UK ones has come down from three to two. The issue also compares the latest rankings with that of 2008 (based on 2007 financials), the last year before the global meltdown hit the financial system, and says the transformation is even more radical. At that time, UK banks were the most profitable, accounting for 11% of the top 1,000 banks.

While total profits have almost recovered to the pre-crisis level, the share of UK banks has fallen to 5%. Meanwhile, the share of Chinese banks has more than doubled to 21% from under 10% in 2007.

Incidentally, Industrial and Commercial Bank of China Ltd (ICBC), the world’s largest lender by market value, opened for business in Mumbai last week.

The “fragmented" Indian banking sector continues to “underperform".

The Indian economy is seven times bigger than that of Malaysia but in the top 25 banks in the Asia-Pacific region excluding China and Japan, in terms of tier I capital (equity and reserves), it has only four entries and Malaysia has three. Australia and South Korea have five entries each. Overall, 32 Indian banks feature in the world’s top 1,000 banks, but only one—State Bank of India (SBI)—is among the top 100, at number 61. In terms of assets too, SBI is the lone bank among the top 100.

While SBI is among the top 50 most valued banks in the world, its market cap is about 13% that of ICBC.

Two other Indian banks—ICICI Bank and HDFC Bank—are among the top 100 in terms of market cap.

Here too the Chinese banks dominate, occupying three of the first five slots.

Clearly, the country’s banks have not been able to reap the benefits of India having the world’s second fastest growing major economy, both in terms of scale and market cap. A pointer to this is the low credit to gross domestic product ratio.

One hopes things will change with the entry of a new set of banks, some of them driven by corporate houses that have the financial muscle. Along with efficiency and robustness, we also need banks with scale to support an economy that many say has the potential to be among world’s top six by the end of this decade.

Illustrations by Jayachandran; Portraits by Shyamal Banerjee; Graphics by Sandeep Bhatnagar and Yogesh Kumar /Mint