What are the benefits and costs to India of an enlarged foreign bank presence? Going by the three important criteria of access to financial services, efficiency and provision of credit, it is unlikely that foreign banks can do more than what the Indian banking system can provide. Add to that the risks posed by larger operations by foreign banks and there is a case for revisiting the 2005 road map of the Reserve Bank of India which indicated that these banks may be able to expand their presence after 2009.
HT PAREKH FINANCE COLUMNjuly 12, 2008 EPW Economic & Political Weekly12Is It Time to Open Up to Foreign Banks?T T Ram MohanT T Ram Mohan (ttr@iimahd.ernet.in) is at the Indian Institute of Management, Ahmedabad.The HT Parekh Finance Column will appear in the second week of every month and will have contributions from a panel of columnists: T T Ram Mohan, C P Chandrasekhar, Avinash Persaud and Suman Bery.What are the benefits and costs to India of an enlarged foreign bank presence? Going by the three important criteria of access to financial services, efficiency and provision of credit, it is unlikely that foreign banks can do more than what the Indian banking system can provide. Add to that the risks posed by larger operations by foreign banks and there is a case for revisiting the 2005 road map of the Reserve Bank of India which indicated that these banks may be able to expand their presence after 2009. In 2005, the Reserve Bank of India (RBI) announced a road map for the presence of foreign banks in India. The policy stated that foreign bank expansion in India would proceed in two phases. In PhaseI, the RBI promised to go beyond the existing commitment of 12 new branches for foreign banks in a year. This was not giving away a great deal in light of the pace of expansion of branches of the new private banks. In PhaseI, acquisition of private banks would be permitted only in private sector banks identified for restructuring and that too in a phased manner. In general, the RBI has not favoured a foreign bank having a stake of more than 5 per cent in a private bank, although there are exceptions such as Ing Vysya Bank. In PhaseII, which was to commence in April 2009, foreign banks could contem-plate mergers and acquisitions with pri-vate banks subject to a ceiling of 74 per cent. Foreign banks’ subsidiaries that had completed a prescribed minimum period of operation would be allowed to list and dilute their stakes so that at least 26 per cent of the equity was held by resident Indians. But, these actions in Phase II would happen after “reviewing the ex-perience with PhaseI” – in other words, the RBI stopped short of making explicit commitments about Phase II.India has been under pressure from the advanced economies to speed up the open-ing of its financial sector for quite some time now. TheRBI policy had the effect of putting the brakes on their ambitions at the very least until 2009. The RBI’s inten-tion was to give time for Indian banks, especially public sector banks, to get their acts together before exposing them to the full blast of foreign competition. Well, 2009 is not far away. So, it is fair to ask: is it time now to open up to foreign banks? This question can be broken up into two parts. One, is a larger foreign bank presence in the country desirable or, to put it differently, what are the benefits and costs that go with such a presence? Two, assuming that we do not want foreign banks to overrun the sector and that some Indian ownership is desirable, how well prepared are Indian banks to cope with foreign competition? In this article, I will confine myself to the first question; the second I will reserve for a later column. The World Bank’sGlobal Development Finance 2008 (GDF) has a chapter that summarises some of the work on the role of international banks. The first thing to note is that, among developing economies, India falls in the category of economies in which the share of banking assets held by foreign banks with majority ownership is on the lower side – under 10 per cent in 2006. India has for company China, Viet-nam, South Africa, Thailand, Philippines and even Turkey, among others. A possible inference is that there is con-siderable scope for an increase in foreign bank presence in India. However, India’s experience in the recent past and the cases of China and Vietnam do suggest that a high foreign bank presence is by no means a precondition for rapid economic growth. Secondly, as the GDF report notes, a higher foreign bank presence is more common in central Asia, sub-Saharan Africa and Latin America than in east Asia, south Asia, west Asia and north Africa. Elsewhere, the report indicates why this is so. Growth of Foreign BanksIn many of the countries that have a high foreign bank presence, this was a sequel to a banking crisis. Banks were often nationalised after a crisis, then privatised through sale to foreign banks as neither the state nor the domestic private sector had the capital to sustain these banks. Even in east Asia, which still has a lower foreign bank presence than other regions, it was only after the 1997 crisis and its devastating impact on the banking sector that foreign banks enhanced their presence.
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW july 12, 200813Elsewhere, one finds other contextual reasons for foreign bank entry. In central and eastern Europe, an opening up to foreign banks has been related to accession of these economies to the European Union. Where, one wonders, are the economies with relatively stable banking systems that have permitted large foreign bank owner-ship without duress of some sort?A third fact, one that is omitted in the report, is that foreign bank ownership in the higher income countries is surprisingly low – it did not amount to more than 10 per cent of assets according to the World Bank’s earlier comprehensive work on banking sector liberalisation, Finance and Growth. Wrong ComparisonsTaking all these facts into account, it makes little sense to compare foreign bank presence in India with that in other econo-mies and argue that we need to catch up with others. We have not had the kind of banking instability that others have gone through, we have seen an improvement in efficiency on a variety of parameters and our banking system does not lack access to capital required for further expansion. Those who argue in favour of a faster opening up to foreign banks must show that such an opening up is more conducive to meeting national objectives – financial deepening, improved efficiency, financial inclusion and the pursuit of larger national objectives such as promoting agriculture as well as small and medium enterprises (SMES). The GDF report contends that indeed many of these benefits are there. It high-lights three principal benefits: improved access to financial services, improved effi-ciency of domestic financial systems, and easing of domestic credit constraints on manufacturing firms. However, these ben-efits are specific to certain contexts. One needs to evaluate whether in the Indian context these benefits will apply and the contentions made in the GDF report will hold.Access to Financial Services?Take the first claimed benefit, improved access to financial services. The report cites several examples. In the Czech Republic, foreign banks were the first to offer ATM and remote banking facilities. In other economies, they have offered sophisticated products such as derivatives. Elsewhere, they have stimulated the development of bond markets. Are these priorities at all in the Indian market? We have not only a good network of ATMs but one of the largest network of branches. When we talk of access to finan-cial services, we mean plain vanilla depos-its and loans, not sophisticated products. One has no difficulty accepting that for-eign banks will spur access to derivatives. Will they be as enthusiastic about offering basic banking services to large numbers of people? It does appear that what the GDF report has in mind when it talks of “access” is not quite what we mean when we talkof “financial inclusion”.Improved Efficiency?Turn now to the second claimed benefit, improved efficiency. The theoretical argu-ment is straightforward: foreign banks bring in serious competition for domestic players, they bring with them superior risk management practices and deeper pock-ets and all this should result in higher effi-ciency in the banking system. Take a closer look at the efficiency argu-ment, however, and you begin to spot a number of holes. For one thing, the improvement in efficiency seen in many economies consequent to the entry of foreign banks may merely reflect the fact that the banking system was in the throes of a crisis before they came in. The improvement may be ascribed largely to the injection of capital into moribund banking systems. We need evidence that in a system that has attained a reasonable level of efficiency and stability, such as the Indian banking system, ceding a large presence to foreign banks will confer large benefits. This sort of evidence is hard to come by if only because, as mentioned earlier, an enlarged foreign bank presence is a sequel to ineffi-ciency and failure in a banking system. Whatever limited evidence we have is to the contrary. Where banking systems are strong and stable, as in Chile prior to foreign banks’ entry, the contribution of foreign banks to efficiency tends to be small. This is also true of systems where financial liberalisation has ushered in competition and spreads have declined. We also need to distinguish between im-provement in efficiency at the firm level and improvement at the sectoral level. Can foreign banks improve return on assets at a given public sector bank? Most certainly. It is not hard to see what this will take: elimi-nate unprofitable branches that exist mainly for reasons of inclusion; downsize staff; exit a number of small, relatively unprofit-able relationships at the retail as well as corporate level; focus on wealth manage-ment products; and make the most of advantages in cross-border transactions. This will produce a more profitable bank. Will it produce a more efficient banking sector, assuming again that we would want a mix of foreign and domestic banks? This is the issue. The danger is that foreign banks will “cherry-pick” the best relationships in the system leaving the domestic banks enfeebled. We may end up having successful foreign banks and a vulnerable banking sector. There may also be different effects on effi-ciency in the banking sector depending on whether foreign banks are entering through the greenfield route – and thus enhancing competition – or whether they are entering by acquiring large banks, which could have the effect of reducing competition. Lastly, ever increasing levels of efficiency cannot be the sole objective for the bank-ing sector. We need a level of efficiency that is consistent with other objectives – finan-cial inclusion, development of agriculture and, not least, financial stability. Is it con-ceivable that we could have achieved the 150 per cent increase in agricultural credit that we have witnessed in 2004-07 with a foreign bank-dominated system? As for financial stability, we have seen how the relentless pursuit of so-called efficiency has led to grave crises in international markets of the sort we are witnessing now.More Access to Credit?Finally, the third significant benefit claimed for foreign banks, greater access to credit for domestic firms. Presumably, this happens for two reasons: a superior ability to assess risk and foreign banks’ ability to access funds outside the domes-tic market. Granting the first advantage, the second is relevant only where domes-tic savings are inadequate in relation to credit requirements.
HT PAREKH FINANCE COLUMNjuly 12, 2008 EPW Economic & Political Weekly12Is It Time to Open Up to Foreign Banks?T T Ram MohanT T Ram Mohan (ttr@iimahd.ernet.in) is at the Indian Institute of Management, Ahmedabad.The HT Parekh Finance Column will appear in the second week of every month and will have contributions from a panel of columnists: T T Ram Mohan, C P Chandrasekhar, Avinash Persaud and Suman Bery.What are the benefits and costs to India of an enlarged foreign bank presence? Going by the three important criteria of access to financial services, efficiency and provision of credit, it is unlikely that foreign banks can do more than what the Indian banking system can provide. Add to that the risks posed by larger operations by foreign banks and there is a case for revisiting the 2005 road map of the Reserve Bank of India which indicated that these banks may be able to expand their presence after 2009. In 2005, the Reserve Bank of India (RBI) announced a road map for the presence of foreign banks in India. The policy stated that foreign bank expansion in India would proceed in two phases. In PhaseI, the RBI promised to go beyond the existing commitment of 12 new branches for foreign banks in a year. This was not giving away a great deal in light of the pace of expansion of branches of the new private banks. In PhaseI, acquisition of private banks would be permitted only in private sector banks identified for restructuring and that too in a phased manner. In general, the RBI has not favoured a foreign bank having a stake of more than 5 per cent in a private bank, although there are exceptions such as Ing Vysya Bank. In PhaseII, which was to commence in April 2009, foreign banks could contem-plate mergers and acquisitions with pri-vate banks subject to a ceiling of 74 per cent. Foreign banks’ subsidiaries that had completed a prescribed minimum period of operation would be allowed to list and dilute their stakes so that at least 26 per cent of the equity was held by resident Indians. But, these actions in Phase II would happen after “reviewing the ex-perience with PhaseI” – in other words, the RBI stopped short of making explicit commitments about Phase II.India has been under pressure from the advanced economies to speed up the open-ing of its financial sector for quite some time now. TheRBI policy had the effect of putting the brakes on their ambitions at the very least until 2009. The RBI’s inten-tion was to give time for Indian banks, especially public sector banks, to get their acts together before exposing them to the full blast of foreign competition. Well, 2009 is not far away. So, it is fair to ask: is it time now to open up to foreign banks? This question can be broken up into two parts. One, is a larger foreign bank presence in the country desirable or, to put it differently, what are the benefits and costs that go with such a presence? Two, assuming that we do not want foreign banks to overrun the sector and that some Indian ownership is desirable, how well prepared are Indian banks to cope with foreign competition? In this article, I will confine myself to the first question; the second I will reserve for a later column. The World Bank’sGlobal Development Finance 2008 (GDF) has a chapter that summarises some of the work on the role of international banks. The first thing to note is that, among developing economies, India falls in the category of economies in which the share of banking assets held by foreign banks with majority ownership is on the lower side – under 10 per cent in 2006. India has for company China, Viet-nam, South Africa, Thailand, Philippines and even Turkey, among others. A possible inference is that there is con-siderable scope for an increase in foreign bank presence in India. However, India’s experience in the recent past and the cases of China and Vietnam do suggest that a high foreign bank presence is by no means a precondition for rapid economic growth. Secondly, as the GDF report notes, a higher foreign bank presence is more common in central Asia, sub-Saharan Africa and Latin America than in east Asia, south Asia, west Asia and north Africa. Elsewhere, the report indicates why this is so. Growth of Foreign BanksIn many of the countries that have a high foreign bank presence, this was a sequel to a banking crisis. Banks were often nationalised after a crisis, then privatised through sale to foreign banks as neither the state nor the domestic private sector had the capital to sustain these banks. Even in east Asia, which still has a lower foreign bank presence than other regions, it was only after the 1997 crisis and its devastating impact on the banking sector that foreign banks enhanced their presence. 
HT PAREKH FINANCE COLUMNEconomic & Political Weekly EPW july 12, 200813Elsewhere, one finds other contextual reasons for foreign bank entry. In central and eastern Europe, an opening up to foreign banks has been related to accession of these economies to the European Union. Where, one wonders, are the economies with relatively stable banking systems that have permitted large foreign bank owner-ship without duress of some sort?A third fact, one that is omitted in the report, is that foreign bank ownership in the higher income countries is surprisingly low – it did not amount to more than 10 per cent of assets according to the World Bank’s earlier comprehensive work on banking sector liberalisation, Finance and Growth. Wrong ComparisonsTaking all these facts into account, it makes little sense to compare foreign bank presence in India with that in other econo-mies and argue that we need to catch up with others. We have not had the kind of banking instability that others have gone through, we have seen an improvement in efficiency on a variety of parameters and our banking system does not lack access to capital required for further expansion. Those who argue in favour of a faster opening up to foreign banks must show that such an opening up is more conducive to meeting national objectives – financial deepening, improved efficiency, financial inclusion and the pursuit of larger national objectives such as promoting agriculture as well as small and medium enterprises (SMES). The GDF report contends that indeed many of these benefits are there. It high-lights three principal benefits: improved access to financial services, improved effi-ciency of domestic financial systems, and easing of domestic credit constraints on manufacturing firms. However, these ben-efits are specific to certain contexts. One needs to evaluate whether in the Indian context these benefits will apply and the contentions made in the GDF report will hold.Access to Financial Services?Take the first claimed benefit, improved access to financial services. The report cites several examples. In the Czech Republic, foreign banks were the first to offer ATM and remote banking facilities. In other economies, they have offered sophisticated products such as derivatives. Elsewhere, they have stimulated the development of bond markets. Are these priorities at all in the Indian market? We have not only a good network of ATMs but one of the largest network of branches. When we talk of access to finan-cial services, we mean plain vanilla depos-its and loans, not sophisticated products. One has no difficulty accepting that for-eign banks will spur access to derivatives. Will they be as enthusiastic about offering basic banking services to large numbers of people? It does appear that what the GDF report has in mind when it talks of “access” is not quite what we mean when we talkof “financial inclusion”.Improved Efficiency?Turn now to the second claimed benefit, improved efficiency. The theoretical argu-ment is straightforward: foreign banks bring in serious competition for domestic players, they bring with them superior risk management practices and deeper pock-ets and all this should result in higher effi-ciency in the banking system. Take a closer look at the efficiency argu-ment, however, and you begin to spot a number of holes. For one thing, the improvement in efficiency seen in many economies consequent to the entry of foreign banks may merely reflect the fact that the banking system was in the throes of a crisis before they came in. The improvement may be ascribed largely to the injection of capital into moribund banking systems. We need evidence that in a system that has attained a reasonable level of efficiency and stability, such as the Indian banking system, ceding a large presence to foreign banks will confer large benefits. This sort of evidence is hard to come by if only because, as mentioned earlier, an enlarged foreign bank presence is a sequel to ineffi-ciency and failure in a banking system. Whatever limited evidence we have is to the contrary. Where banking systems are strong and stable, as in Chile prior to foreign banks’ entry, the contribution of foreign banks to efficiency tends to be small. This is also true of systems where financial liberalisation has ushered in competition and spreads have declined. We also need to distinguish between im-provement in efficiency at the firm level and improvement at the sectoral level. Can foreign banks improve return on assets at a given public sector bank? Most certainly. It is not hard to see what this will take: elimi-nate unprofitable branches that exist mainly for reasons of inclusion; downsize staff; exit a number of small, relatively unprofit-able relationships at the retail as well as corporate level; focus on wealth manage-ment products; and make the most of advantages in cross-border transactions. This will produce a more profitable bank. Will it produce a more efficient banking sector, assuming again that we would want a mix of foreign and domestic banks? This is the issue. The danger is that foreign banks will “cherry-pick” the best relationships in the system leaving the domestic banks enfeebled. We may end up having successful foreign banks and a vulnerable banking sector. There may also be different effects on effi-ciency in the banking sector depending on whether foreign banks are entering through the greenfield route – and thus enhancing competition – or whether they are entering by acquiring large banks, which could have the effect of reducing competition. Lastly, ever increasing levels of efficiency cannot be the sole objective for the bank-ing sector. We need a level of efficiency that is consistent with other objectives – finan-cial inclusion, development of agriculture and, not least, financial stability. Is it con-ceivable that we could have achieved the 150 per cent increase in agricultural credit that we have witnessed in 2004-07 with a foreign bank-dominated system? As for financial stability, we have seen how the relentless pursuit of so-called efficiency has led to grave crises in international markets of the sort we are witnessing now.More Access to Credit?Finally, the third significant benefit claimed for foreign banks, greater access to credit for domestic firms. Presumably, this happens for two reasons: a superior ability to assess risk and foreign banks’ ability to access funds outside the domes-tic market. Granting the first advantage, the second is relevant only where domes-tic savings are inadequate in relation to credit requirements. 
