India’s Plan for Bank Mergers Ignores History and International Consensus

Obese banks are generally unhealthy for the economy. But the government is happily fattening banks thinking they are becoming “stronger” in the process.

Increasing the size of SBI is a poor banking policy. Credit: Reuters/Danish Siddiqui/Files

Increasing the size of SBI is a poor banking policy. Credit: Reuters/Danish Siddiqui/Files

The Union cabinet’s decision to merge-and-consolidate India’s public sector banks (PSUs) is in direct opposition to the post-2008-crisis consensus that big banks are a systemic risk to their national economies. In the US and the UK, political campaigns have been run advocating break-up of big banks.

The term ‘too important to fail’ (TITF) is increasingly used in mainstream media coverage of the global economy. In 2014, the International Monetary Fund (IMF) published a paper listing all the risks associated with big banks, a study explicitly linking bigger size with riskier behaviour, forced government subsidies and even weakening of national sovereignty. After multiple investigations into the 2008 US economic crisis, leading bankers across the world have now said banks stay nimble and serve the economy better when small in size.

One of the most dangerous outcomes of bank consolidation is the embedded incentives in favour of risky behaviour. Once banks get to the TITF stage, they realise that they will be bailed out by respective governments even if their risks backfire. The case for bailing a reckless bank becomes even more compelling when they are systemically important banks (SIBs). An SIB is a financial entity whose collapse can seriously threaten the stability of the national economy.

Effect of TITF protection on a simplified bank balance sheet. Source: Global Financial Stability Report 2014, IMF

Effect of TITF protection on a simplified bank balance sheet. Source: Global Financial Stability Report 2014, IMF

The State Bank of India (SBI) has been already denoted as an SIB by the Reserve Bank of India. Increasing the size of SBI is a poor banking policy. Earlier in 2017, SBI has merged operations of five of its associate banks and Bharatiya Mahila Bank signaling a determined push towards consolidation in the sector, following the bad loans crisis. The merger has reduced the number of state-controlled banks to 21 from 26.

The principal advisor to the finance ministry, Sanjeev Sanyal, has reportedly said that the government is seeking ways to reduce the number of existing public sector banks to a range between ten and 15. He has said consolidation will not be taken too far so that the numbers of PSUs come down to four or five, lest the new banks become TITF. However, Sanyal has not clarified the basis on which he has calculated that four-five are TITF and not ten-15.

He has also not clarified how exactly a bank becomes ‘stronger’ when it is bigger, and how exactly size solves the problems of bad loans. Under the Indradhanush plan, the bigger banks will be recapitalised by the government. So if it actually recapitalisation helping banks become stronger, then why not recapitalise existing banks without merging them?

Proponents of bank consolidation argue that size should not be linked to risky behaviour, which they cite as an independent variable. They also cite the role of rating agencies that will flag risky behaviour of banks with lower ratings, thereby monitoring risk. However, as per the IMF, size is absolutely linked with risk – size insulates entities from disciplinary action by the government and if any organization realises there is no downside to risk, it is prone to indulge in it.

Secondly, rating agencies can no longer be trusted for effective vigilance of institutional behaviour. Their disastrous record in the run up to the 2008 financial crisis is well known in international banking circles. Some of the world’s most respected rating agencies had assigned AA ratings to American banks days before the latter collapsed. The reasons, given for this failure of the rating agencies, range from incompetence to collusion.

Media propaganda in favour of bank consolidation

There are a number of other weak reasons supporting big banks, which are repeated by sections of the media eschewing critical examination. For example, a Quartz article quoted the following statement from an auditor without verifying the veracity of the claim or even deconstructing what it meant.

“Consolidation will help by marrying two banks that have similar structures and are chasing the same goal. The banks will be able to better channelise the resources and function more smoothly if they are being controlled by one strong management team.”

This kind of reasoning is basically arguing in favour of monopoly by the service provider, a decision which is not in consumers’ interest. If two entities servicing the same set of people merge, then they naturally lose the incentive to compete with one another. Secondly, as a merged entity they become even more difficult to discipline in case of predatory behaviour. And lastly, if the risky behaviour of the merged entity backfires, then it is difficult to let them self-destruct because they are the only player in the market. Hence, bailouts using taxpayer money follow – a chain which clearly demonstrates that when special interests make mistakes, society bails them out – but when ordinary individuals find themselves in the same position, the invisible hand of the market metes out visible punishments.

The same article goes on to argue

The mergers are also expected to reduce the pressure on the government to secure capital for PSBs. State-owned lenders may need Rs1.8 lakh crore of capital infusion by FY19, it has been estimated. Of this, Rs 70,000 crore will be pumped in by their largest shareholder, the government. The onus to raise the balance is with the banks themselves. The merged, stronger, and competitive entities will, thus, be better placed to attract funds lead to operational efficiency and economies of scale.

The last part of the paragraph warrants scrutiny. If the worldwide consensus has stated undesirability of big banks, two important questions follow. Which institution would invest in an already risky structure? If an institution invests anyway, what guarantees have been given for it to recover money should things go wrong?

Bleaker future

The government’s poor ideas on banking reform do not stop at consolidation and bloated structures. The government is going out of its way to promote risky behaviour by also aiming to diversify holding patterns in bank shares. Finance minister Arun Jaitley has been quoted saying, “… we have announced a policy that government holdings [in banks] to be brought down to 52%.”

This intent if implemented, will also manipulate ownership patterns in a way that incentivises risky behavior. A diverse holding pattern of bank ownership actually creates the free rider problem. This scenario implies that when multiple entities hold ownership in an institution, every individual owner has limited agency in controlling risky behaviour of the management. By divesting their stake, governments insulate themselves from criticism of mismanaging major public institutions. Every major shareholder blames ‘the board’ excluding its own involvement, and when the music stops taxpayers find themselves holding the bag they must now fill.

Sampad Patnaik is a freelance journalist.

  • alok asthana

    Well brought out. Thanks.