Rajan predicts ‘revolution’ in banking industry

The Reserve Bank of India (RBI) is contemplating a range of measures to increase competition in the Indian banking sector, which Raghuram Rajan believes is a "necessity" if the country is to "finance the enormous needs of the real economy".

Rajan, the RBI governor, delivered an impassioned speech at the Competition Commission of India on Tuesday, where he laid out the two "grand bargains" between banks and government that shaped the country's present financial landscape – and more recent developments that are breaking them down.

Under the first bargain, he explained, commercial banks received low cost deposits, access to the RBI's liquidity facilities and "some protection from competition" in return for financing the government, opening branches in unbanked areas and making loans to priority sectors (farmers and students, for instance).

Rajan said this bargain is "under threat" as banks increasingly face competition from financial markets and real assets for household savings, while the government "cannot continue to pre-empt financing at the scale it has in the past".

The central bank is "committed" to lifting the barriers of entry facing new banks. It granted two new commercial bank licences last month and is moving towards a system where banking licences will be available all year round – or "on-tap", as Rajan put it.

This does not mean that every pretender will be handed a licence – Rajan stressed that only "those who have a proven track record and reasonable capital" will be approved. There are, however, ‘differentiated' licences available for smaller institutions and "those who see synergies in doing only one part of the banking business" such as payments.

"Small banks tend to be better at catering to local needs, including needs of small and medium businesses," Rajan explained, while "a payments bank, which will take deposits and offer payment and remittance services but be constrained to invest all its funds in safe instruments such as government securities, could be very synergistic with other existing services."

Not everyone is convinced of their value. Rajan said some of his colleagues at the RBI consider payments banks "unviable", while others are concerned they would "skim the cream of banking business away from regular commercial banks". Rajan, however, seems ready to take a leap of faith.

Payments banks would, he argued, reduce the obligations imposed on commercial banks, specifically by buying government securities (for liquidity purposes) and allowing commercial banks to diversify.

Rajan also called for changes to the role commercial banks play in achieving financial inclusion. Even if they are forced to extend financial services to remote areas, he said, banks will not necessarily reach out to the local population.

"The reality is that if the mandate is unprofitable, banks will find ways to avoid them," he said. "Not all forms of inclusion can be made profitable, but we should give banks the freedom to try new approaches, perhaps drawing in other institutions that can traverse the last mile to the underserved where necessary."

The second bargain Rajan outlined was between the public sector banks and the government. These banks undertook "special services and risks" for the government, he explained, and received their backing in return.

Public sector banks tend to fund large, risky infrastructure projects. Rajan warned this kind of financing is becoming more sophisticated, and public sector banks may struggle to meet the new challenges as "past hiring freezes have decimated their middle management" and they are "constrained by government rules and second-guessed by vigilance authorities".

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