The government is reported to be promoting a reduction in the number of banks through consolidation of the big banks with the weaker small banks. Bank consolidation was popular prior to the global financial crisis of 2008-09. But then big banks got into serious financial difficulties in the USA and several European countries which were members of the EU. They had to be bailed out by the governments with public money. The justification for this bail out was that the big banks were too big to be allowed to fail for it would pose a systemic risk to the whole financial system. But several economists pointed out that in fact, no clear evidence had been presented that would substantiate claims that the failure of an institution that was bailed out would have jeopardized the entire financial system.
Some opposed the bail-out of the big banks with public money. They point to regulatory failure as the cause of the financial crisis. Government agencies failed in their role to raise red flags about individual institutions as they were expected to do as an early warning system. They say decisions about which banks to bail out were poorly articulated and this has undermined public confidence and hampered economic recovery. Economists point out that it was the financial reforms of 1991 ( FDICIA) which allowed for the bail out of firms believed to pose a systemic risk to the financial system which created strong incentives for consolidation in the banking industry in the 1990s and 2000s. This consolidation led to the proliferation of mega-banks during the period creating the "too big to fail" situation. So they blame the regulations for creating too-big- to-fail mega banks.
The development of banking has been too narrow and exclusive
The Troubled Asset Relief Program (TARP) in the USA is a lending program originally intended to relieve commercial banks of their faltering mortgage loans. But the banks that received the funds did not resume lending and thereby delayed the economic recovery. So some economists say that policymakers should simply allow for the closing of failed institutions, no matter their size or complexity.
Anyway the lesson for us is that "bigness" is no guarantee that banks will not fail if they resort to risky lending. But our banks do not lend to risky enterprises. The small and medium enterprises are treated as risky and shunned by our banks. This attitude stems from our banking traditions. During the colonial times the British banks set up shop here to finance the Agency Houses which managed the tea plantations. They sent the teas to the London auctions where they were sold to foreign buyers. These banks largely ignored the Ceylonese businessmen who had to be guaranteed by the shroff to qualify for loans from the banks. The Pochkanawala Commission went into these grievances of the local businessmen and their recommendation was to set up a Ceylonese owned bank. The Bank of Ceylon was set up to meet the needs of local businessmen.
In 1956 a new class came to power and this class included small businessmen based in small towns who were supporters of the SLFP. The SLFP government took over the Co-operative Federal Bank and created a new bank to fund the co-operative sector and provide agricultural credit through the rural co-operative societies. It was called the People’s Bank. Soon the People’s Bank gave priority to SLFP businessmen over the co-operatives and the bank was designated as ‘some people’s bank’ by the cartoonist Wijesoma.
The Central Bank was very reluctant to grant new banking licenses until the late N.U Jayewardene set up the IT-driven Sampath Bank introducing many innovative features like the ATMs. But the competition in banking is still inadequate since the two State owned banks account for over 50% market share. These two banks set the interest rates charging higher rates from the private sector to cross-subsidize the State sector. All the other banks follow the leaders and set their interest rates to match those of the two state- owned banks.
Too little competition
There is also very little competition either in deposit mobilization or in lending. The Central Bank dictates through moral suasion the interest rate on deposits and hence competition is limited to service rather than price. There are also the branches of the big foreign banks. They confine their business to the large corporate clients. They are not interested in deposit mobilization but draw their funds from the inter-bank money market.
The banks are also confining their lending to trade finance which was the traditional function of the Exchange banks. They make money from foreign exchange transactions particularly where the exchange rate is free to fluctuate according to market forces. The SMEs which contribute to over 70% of the GDP are starved of credit. The banks do not lend on the strength of the balance sheet of the enterprise but insist on the proprietors and directors of small companies providing personal collateral in the form of land and property. Businessmen have to pledge their private assets to get credit for their businesses. By promoting consolidation of small banks with big banks the authorities will restrict competition further. Consolidation is likely to affect the supply of credit to the SME sector adversely. The SMEs have to rely on the smaller banks and other financing institutions. They rely less on the big national banks but more on the smaller and newer banks.
Firms consolidate by mergers and acquisitions when there are economies of scale or synergy. The bigger banks are likely to have a lower cost of funds than smaller banks. A large bank can mobilize deposits cheaper and the interest rate control on deposits will help them to do so since they are likely to enjoy greater public confidence. But the beneficiaries are the banks themselves rather than the borrowers for the rates are more or less fixed to give a minimum interest margin of 4% and only the prime borrowers will benefit if at all. With the lack of competition, the bigger banks can retain the benefit of a lower cost of funds instead of passing it to borrowers. So any bank consolidation to enable a lower cost of funds will benefit the banks managers and their shareholders rather than the borrowers.
The Central Bank has placed limits on shareholdings to prevent control of the banks by a few businessmen. But won’t consolidation lead to concentration of bank shareholdings giving power to a fewer businessmen? Worse, they will increase the control of the government which is detrimental to commercial operations. It will mean greater state control. We are already seeing the control exercised through the investments by the EPF. It will mean politicization of banking as well.
Too big to fail?
Risk in bank lending depends on the pattern of lending. Those banks that lend to small and medium enterprises run greater risks. Similarly any concentration of lending for a particular sector, say pawning, may have higher risks than others. The smaller banks which tend to lend more to the SMEs therefore face higher risks. The smaller banks also tend to have concentration of assets which also increase risks. It is true that smaller banks are more vulnerable to external shocks than the bigger banks. But bigness alone does not make a bank less vulnerable. It is the duty of the regulator to monitor the risks of the banks and sound an early warning to those taking on too many risks for a particular sector. Promoting bank consolidation cannot relieve the regulator of his role to monitor the performance of the banks. The authorities are promoting consolidation by offering tax relief. But a merger or acquisition should be based on business factors rather than a mere tax concession. If there is pressure applied for the bigger banks to take over the smaller banks, then the strength of the bigger banks may themselves be adversely affected.
If the banks on their own judgment wish to merge with other banks it is necessary to allow them. But why should the government intervene in such business decisions? When Seylan Bank was under threat of a run the Central Bank took it over and it became a government controlled bank. The authorities have also appointed central bankers to the boards of the big banks not merely for oversight but to commanding positions. Will they be expected to toe the line of the government and deprive the professional bankers the exercise of their judgment? Central banking is different from commercial banking and requires different skills and aptitudes.
Mr. Chidambaram recently urged the Reserve Bank of India to issue more banking licenses. He said amendments to the banking law are also being brought before Parliament. The minister also called upon senior bankers to adopt different business models rather than all following the same model. He said "there is an uninhibited tendency to stress on uniformity.’’ He said he does not think that one bank should be a clone of another. Our banks are all clones of the same model of the earlier exchange banks. Bank consolidation through government pressure will mean the perpetuation of the clones.