By Suyash Rai, IFMR Finance Foundation
In what could become a welcome trend, the RBI has started putting out detailed discussion notes on future policy steps. Recently, the central bank released a discussion paper presenting the pros and cons of various approaches to new bank licenses . Though the paper doesn’t clearly favour any particular structure, it does seem to be tilting towards or away from certain possibilities. One possibility that the paper seems to be almost squarely opposed to is of allowing more small banks to be set up in the country. The paper lays out some arguments opposing the idea of small banks, and cites experience with small banks like local area banks and urban cooperative banks to make a case against them.
As far as performance of local area banks is concerned, the record in itself doesn’t prove that the small banks don’t stand a chance. The Indian experience with such banks has been a mixed one, and there are examples of well performing banks in almost every category of small banks (local area banks, district credit cooperative banks, urban cooperative banks, etc), as there are of non-performing ones. This is true for big, national banks as well. This process is inherent to the process of development of institution-types, and the key is to ensure learning and application of “design principles” that make banks successful, rather than writing off entire categories of institutions. If there are indeed inherent weaknesses in the model, which are unmanageable, then the model should very well be discarded. If there are advantages in the model, and weaknesses that can be managed by some structural innovations, then there is no real need to discard the small banks model itself.
Before we consider the challenges to stability and continuity of small banks, and ways of managing these challenges, the key question to ask is: what really are the advantages of small, local banks? Interestingly, the RBI paper cites financial inclusion (i.e. expanding access to financial services) as the main objective for providing more bank licenses. Let’s stay with this objective. Firstly, small banks have proven advantages in processing “soft” information, which is crucial for lending. Professor Jeremy Stein of Harvard University has argued that such institutions are likely to be more successful when information is “soft” and cannot be credibly transmitted. In contrast, large hierarchies perform better when information can be costlessly “hardened” and passed along . There is documented tendency for bank mergers to lead to declines in small-business lending. Studying the empirical evidence on large/multi-national banks, Professor Atif Mian of University of California, Berkeley, shows that greater cultural and geographical distance between a foreign bank’s head quarter and the local branches, leads it to further avoid lending to “informationally difficult” yet fundamentally sound firms requiring relational contracting . Greater distance also makes them less likely to bilaterally renegotiate, and less successful at recovering defaults. The small/domestic banks have been shown to have more smaller/local (profitable) clients. Such differences can be economically large enough to permanently exclude certain sectors of the economy from financing by such large banks.
This ability to process soft, local information is particularly crucial in India, where “hard” information (credit history etc) about a vast majority of people is not readily available. In other words, the main way for banks to know about most clients in India is to access and process local knowledge, mostly captured through local presence, and small banks have proven to be much better at doing this. Big banks tend to skim the surface, where small banks can and usually do go deeper and provide services to many more.
Complete financial inclusion means providing financial services in a high quality, so that people use the services actively. Quality can be understood in terms of the convenience, flexibility and reliability of these services, which are universal terms, but must be defined locally. For example, different timings for bank branch may be deemed convenient in different parts of the country, and this has to be managed on the basis of local understanding. The second big advantage of a small bank is its ability to be agile about local preferences for providing convenience and flexibility required to use banking services effectively. Thirdly, if an institution’s horizontal growth (across geographies) possibilities are limited, it has greater incentives to try harder to grow vertically, by serving more people in the geography and providing more services to the same clients, enhancing the financial inclusion agenda.
Now, let’s consider some of the weaknesses/challenges identified by the RBI discussion paper. According to the paper, the key inherent weaknesses of the small, local area bank model are: a) unviable and uncompetitive cost structures due to small size, b) high concentration risk and higher risk of adverse selection due to geographical concentration, c) limited ability to attract professional staff and competent management due to salary and location constraints, and d) lax governance standards because of concentrated ownership. Though these could be critical challenges to stability and continuity of small banks, there are ways to mitigate most of these weaknesses. For example, the concern about costs is primarily related to the inability of small banks to incur large capital expenditures for deploying systems like core banking systems, or risk management platforms. Innovations in recent times have made it possible to develop and offer these systems Application Service Provider (ASP) form, wherein the user doesn’t need to incur large establishment expenses, but pays on the basis of usage. The software industry is churning out such solutions regularly.
The concentration risk can also be managed if the risk is properly managed by the bank, with systematic risk regularly transferred to entities or markets able and willing to hold the risk for a fee. For example, a local area bank is highly vulnerable to risk of flood in the area, which would lead to a run on the deposits and high defaults on loans. A big part of such systematic risks should be transferred out from the small bank’s balance sheet, while the bank should hold the risks it can manage. This could be done by securitization or parametric insurance on the portfolio, and could be made mandatory by RBI. Also, these banks can be asked to maintain higher capital adequacy. In some cases, the regulator could severely restrict the ways in which the bank can use the savings mobilized. For example, it could make it mandatory to invest most or all of the short-term savings in cash or government securities (narrow banking). Other such solutions could be considered for managing this weakness.
Attracting professional staffs and management is easier if the bank, true to its nature, focuses on recruiting and nurturing local talent. Corporate governance issues can be best addressed by requiring that the ownership is not very concentrated, and the board composition is a healthy mix of independent directors, executives and promoters. Also, oversight of these institutions could be strengthened by regular and close monitoring by investors and lenders to the bank. If the system is made transparent and market-based, the market participants would be incentivised to monitor the institutions and ensure quality, thus adding to the regulation and supervision by the regulator.
The key point is that, if we do acknowledge the important advantages of small banks in meeting the objective of financial inclusion, we can find many ways of addressing the challenges cited in the RBI paper. There are strong reasons to believe that the advantages are substantial enough to find and deploy these solutions.
Interestingly, the issue of optimal size of the banks is being debated internationally, especially in wake of the recent financial crisis, which has once again brought forward questions about the optimal size of banks from the point of view of service quality as well as systemic risk. Emergence of more high quality small banks could create a more fragmented and competitive banking sector, which will also minimize the “too big to fail” threat that much of the world banking sector faces.
This argument for more small banks in no way undermines the importance of other financial institutions. World Bank’s Chief Economist Justin Lin recently wrote a paper arguing that small local banks are the best entities for providing financial services to the enterprises and households that are most important in terms of comparative advantage. While his argument for small banks is spot on, he also argued that the size and sophistication of financial institutions and markets in the developed world are not appropriate in emerging markets. This is not necessarily true, because small banks and larger financial institutions/markets complement each other in many ways. While the former have distinct advantages in delivering high quality services at the front-end, the latter are required for managing certain systematic risks at the back-end, providing support to small banks for designing appropriate products, and supplying capital for small banks and large projects.
High quality small banks can carry forward what effectively started in the last round of bank licensing in 1993. From the cohort that started with that round of licensing, the banks that managed to succeed (like ICICI Bank and HDFC Bank) carried the paradigm of banking to the next level, taking it forward from what the then existing banks were doing, thus expanding access to a much larger number of people. They did so with increasingly sophisticated products and higher levels of efficiency. Small banks can take this process to the next stage, picking up from what these banks have done (or are doing), and taking the banking revolution to the next frontiers – the remote, rural areas, and the under-served parts of population in urban areas.