Sunday, October 16, 2005

Article in The Hindu

Date:16/10/2005 URL: http://www.thehindu.com/thehindu/op/2005/10/16/stories/2005101600051400.htm
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Are small banks viable?
K.R. SRIVARAHAN
AN INTENSE debate is now on in our country regarding the desirability of allowing small banks (either in the private or public sector) to continue as independent entities. Finance Minister P. Chidambaram has been advising the banks to aim at 3-Cs, namely consolidation, competition and convergence.
The basic premise of those arguing for the merger of small banks with large ones is that small ones per se are not potentially viable. It is contended that margins/spreads in banking business keep narrowing and therefore banking has become a "volumes game." Only the big players can survive; smaller banks have either to become big (organically or through mergers) or to go out of the scene.
The counter-argument is that the sustainability of the banking business depends on efficiency and governance; size is not the deciding factor. Banks have gone under not because they were small, but because they were ill-governed. Barings Bank, by no means a small one, collapsed because its systems were leaky and the camouflage of one person (Nick Leeson) was enough to undo a banking behemoth. Nearer home, GTB bit the dust owing to gross irregularities in management. New Bank of India and Nedungadi Bank lost their identity on account of lack of good governance.
There is always some inherent merit and some innate demerit in size. Big banks like State Bank of India and ICICI Bank are certainly able to take advantage of economies of scale, garner low-cost deposits and offer low-interest credit products. They can easily afford to put in place effective risk management systems and thereby avoid, at least theoretically, accumulation of distressed loans. Some large banks are alert enough to securitise and sell their potentially non-performing assets well in advance. It is another debate altogether whether these are desirable or sharp practices.
Empirical evidence
Size, however, is not a guarantee against judgmental errors. Empirical evidence suggests that the proportion of contaminated assets among larger loans is higher. The advantage of large-sized banks is that they can weather the shocks of large loan losses with less strain than the smaller ones. In this context, it is interesting to note that "small versus big banks" debate is taking place in many countries now. For example, Judy Wasylycia-Leis, an MP belonging to the New Democratic Party of Canada, has written to Canada's Minister of Finance, in a letter dated August 12, 2005, as follows: "We do not believe that large size of banks — resulting from bank mergers — improves our economy. Few benefit from Canadian banks such as CIBC losing billions on unproven investments such as Enron, yet permitting more Enron activities abroad is the central goal of current merger talks." This may be an ideologically loaded statement, but this also shows that bigness is not a panacea.
Small banks, on the other hand, ensure `financial inclusion.' They take care of financial needs of many small customers who may get marginalised by larger banks. Social desirability of this aspect is also stressed by Federal Reserve Bank of Chicago in its 2004 annual report. To quote: "On a dollar-for-dollar basis, community banks make nearly three times as many small business loans as the typical large banking company, and they rely more than twice as much on small deposit accounts for funding. These are long-run economic relationships — community banks do not sell off the loans they make to local businesses, and they consider their depositors to be permanent customers, not just sources of funds."
Size is crucial especially in capital-intensive industries. Surprisingly, despite the much talked-about Basel norms, banking is not equity intensive. Public deposits, which are basically debts for the banks, are typically more than ten times as much as the owned funds of banks. With such a high leverage, bigger banks obviously pose a much higher systemic risk. Hence, size can be counter-productive.
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