The Hindu Business Line : Why small banks are still not passé

CONSOLIDATION is the hot issue in Indian banking now. The Finance Minister points out that the imperatives of globalisation and the competition that it will bring in call for the emergence of mega-financial institutions which can take on the "best" in the world.

The implication is that mergers and acquisitions even from now should be the preferred means of consolidation rather than forced consolidation from a weakened competitive position.

The Finance Minister's observations are primarily directed at the large public sector banks. But they nevertheless throw up the question whether small banks are passé in the current and emerging economic environment.

Would they continue to have a relevant and workable business franchise? What will their focus customer segments be — on the funding and asset sides? Will the economies of scale, which a prospective mega-financial institution can offer, undercut the small banks' pricing on both the funding and lending sides? In sum, how profitable will a small bank franchise be when large, complex intermediaries come into being?

Small banks' role in local intermediation

An analysis of the issue indicates that far from being rendered irrelevant, small and local banks could continue to have a crucial role in overall financial intermediation in the economy. As the economy grows (at the present clip of 6.5-8 per cent p.a.), more people are drawn out of poverty and overall living standards improve, there will be a concomitant need for deeper, more penetrative financial intermediation. Such financial intermediation at the level of regional and sub-regional markets may be possible only for smaller/localised institutions.

The rapid growth in residential mortgage financing in the country in the past couple of years provides evidence for this hypothesis. Here is possibly a business segment whose growth potential has just been tapped. Niche banking would have a place in such a scenario as smaller intermediaries tailor their products/services to local and regional needs.

Ironically, it is the United States banking sector which possibly is the inspiration for the consolidation advocates (CitiBank, JP Morgan Chase, Bank of America — three institutions which have put through some mega consolidation exercises in the recent past and emerged larger, more complex global organisations readily come to mind) which also points to a continued meaningful role for smaller, local banks.

Bank structure in US

It is an interesting piece of statistic that there are currently around 8000 commercial banks in the US. Of course, this is a notable reduction from the 13,000 or so banks which were operating two decades ago. Consolidation, of course, has been happening in all segments of the banking industry there — be it the large international, national, regional or community banks' segments.

But the key point to note here is that in the past five years, two new bank charters were granted for every five bank mergers (Fed Reserve data). Moreover, close to 90 per cent of the 8000 banks are institutions with up to $1 billion in assets — that is, around Rs 5000 crore. And these small/local banks seem to be thriving if their balance sheets and income statements are any indication.

Fed data show that capital ratios, profitability, asset quality and efficiency parameters for these small banks are not very different from that for the large banks — that is, banks with assets of $10 billion and more. Some of the bigger community banks score even better than the bigger national banks on the above parameters.

Relevance for India

If the small bank concept (community banks as they are called in the US) is found relevant and crucial for the US economy, one wonders how it would not be applicable in the Indian context also.

Indeed, given the size of India, the large population and the diverse economic profile, the small bank structure would be (or should be) an automatic and preferred choice here.

The opportunities on the lending side for smaller banks seem to be quite plentiful in a growing economy. On the funding side, though, challenges could crop up as in the prevailing banking structure, all categories of banks are competing for the same funding base — retail deposits.

We do not yet have a stratified structure with respect to the sources of funding for banks. Retail deposits still account for 90 per cent plus of the total borrowed liabilities of commercial banks. Recourse to the wholesale financial markets for funding — be it the on-shore rupee market or the offshore foreign currency markets — is still in a limited stage.

This is quite unlike the situation obtaining in the US where there is a clear segmentation amongst the following categories — the big money centre banks which rely to a significant extent on the wholesale markets for their funding, the national, regional and the community banks which rely to different extents on a retail deposit funding pattern.

Of course, a much higher level of reliance on the wholesale market as a funding source brings in its own challenges, both for financial intermediaries and the regulator.

Systemic risk would possibly acquire different dimensions. On the plus side though, the monetary policy transmission mechanism could get strengthened as the central bank's interest rate moves more quickly (in relative terms) through into the financial system.

Some early steps though seem to be in the pipeline towards permitting financial intermediaries a greater level of access to wholesale markets funding. An RBI technical committee has recommended, for instance, that banks' recourse to the overnight money markets can be linked to the level of their capital funds (Tiers 1 and 2) instead of to their owned funds as at present.

The future

It appears inevitable that a stratified banking structure is what would serve best the financial intermediation needs of a large economy like India. As macro policy evolves and the economy and market size grow, there will be a need for different levels of financial intermediation and different kinds of products/services. The small banking franchise should continue to be profitable.

(The author is Associate Vice-President (Treasury), ING Vysya Bank Ltd. These are purely his personal views.)

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