The Indian banking system has emerged unscathed from the crisis. We need to ensure that the banking system grows in size and sophistication to meet the needs of a modern economy. Besides, there is a need to extend the geographic coverage of banks and improve access to banking services. In this context, I am happy to inform the Honourable Members that the Reserve Bank of India (RBI) is considering giving some additional banking licences to private sector players. Non-banking financial companies could also be considered, if they meet the RBI’s eligibility criteria." Thus, spake the then finance minister Pranab Mukherjee while presenting the budget for the financial year 2010-11.

That set off a chain of actions from the RBI. In August 2010, RBI released a discussion paper on the entry of new private banks. In December that year, it released a gist of comments on the discussion paper. In August 2011, the RBI released draft guidelines for issuing new private bank licenses. According to Tamal Bandyopadhyay in Mint on Monday, these draft guidelines have not evolved into a final set of licensing guidelines because the RBI would like to have the power to supersede the board of a rogue bank and that it requires amendment to the Banking Regulation Act of 1949. He points out that the central bank had been making the case for consolidation in the banking sector instead of letting the crowd swell.

In the meantime, if newspaper reports are to be believed, the government has begun pressing the RBI to issue final licensing guidelines and start inviting and accepting applications for the setting up of new banks. For good measure, these reports also invoke the name of the new economic adviser to the Government of India although in his last known stance on the matter, he had opposed the entry of corporate houses into the banking sector due to the inherent conflict of interest in such an arrangement.

The central bank must continue to move with caution if it has to move at all on this matter, in the first place. The very premise of the announcement made by Mukherjee in 2010-11 has been demolished by the subsequent distress in Indian banking assets. Simply put, Indian banks have not emerged unscathed from the global crisis. Further, the crisis of governance in India and cronyism that goes hand in hand with it, have burdened them with non-performing assets, forcing them to resort to creative exercises to camouflage them.

The case for more private banks in the name of financial inclusion is weakly made. If financial inclusion were the alleged goal of allowing more banks to come into existence four decades after bank nationalization, then obviously something is wrong with the operating model of the banking system in the country. In fact, it was left to the microfinance sector to begin to make a serious dent toward financial inclusion, before it ran into political opposition in Andhra Pradesh. In April 2011, Raghuram Rajan had stated that one could consider generating more competition within the banking sector by first allowing non-banking finance corporations and microfinance institutions into banking, before considering other options.

In any case, competition within the banking sector comes with mixed benefits, if at all. Competition squeezes margins and forces banks to seek and accept excessive risk to generate returns for shareholders and compensation for executives. That is what happened in the western world culminating in the crisis of 2008. There is no reason to believe that Indian bankers are cut from a different cloth. Even if they are, the operating environment leaves them little room for restrained asset expansion.

Nearly 70% of bank assets are bottled up in cash reserve ratio, statutory liquidity ratio and priority sector lending obligations, leaving only 30% of the balance-sheet to generate acceptable returns for shareholders. This environment is ripe for excessive risk-taking and that too in a country in which the financial markets are shallow and are still dominated by short-term speculative players. Furthermore, bank loans are mispriced because the benchmark government bond yield is artificially suppressed to keep the funding cost for profligate governments from rising too much.

The global financial crisis of 2008 had thrown up questions about the appropriate role of the banking sector, let alone the need for the presence of numerous players. Banking competition could undermine systemic stability. Fiscal populism, high fiscal deficit and short-term oriented financial markets pose additional challenges for banks. Further, in the absence of clean governance and cronyism-free capitalism, taxpayers will end up funding political parties through the banking system.

India’s hubris over economic growth and banking stability has been punctured. Therefore, a policy proposal that arose from hubristic sentiments deserves to be freshly examined at the minimum, if not buried.

V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at baretalk@livemint.com

To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk

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