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Banking Reform in India∗ - page 40 / 57





40 / 57

Once again the fact that the ”new” private banks pose a problem: So far none of them have defaulted, but they are also new, and as a result, have not yet had to deal with the slow decline of once successful companies, which is one of the main sources of the accumulation of bad debt on the books of the public banks.

On balance, we feel the evidence argues, albeit quite tentatively, for privatizing the national- ized banks, combined with tighter prudential regulations. On the other hand we see no obvious case for abandoning the “social” aspect of banking. Indeed there is a natural complementarity between reinforcing the priority sector regulations (for example, by insisting that private banks lend more to agriculture) and privatization, since with a privatized banking sector it is less likely that the directed loans will get redirected based on political expediency.

However there is no reason to expect miracles from the privatized banks. For a variety of reasons including financial stability, the natural tendency of banks, public or private, the world over, is towards consolidation and the formation of fewer, bigger banks. As banks become larger, they almost inevitably become more bureaucratic, because most lending decisions in big banks, by the very fact of the bank being big, must be taken by people who have no direct financial stake in the loan. Being bureaucratic means limiting the amount of discretion the loan officers can exercise and using rules, rather human judgment wherever possible, much as is currently done in Indian nationalized banks. Berger et al. have argued in the context of the US that this leads bigger banks to shy away from lending to the smaller firms.50 Our presumption is that this process of consolidation and an increased focus on lending to corporate and other larger firms is what will happen in India, with or without privatization, though in the short run, the entry of a number of newly privatized banks should increase competition for clients, which ought to help the smaller firms.

In the end the key to banking reform may lie in the internal bureaucratic reform of banks, both private and public. In part this is already happening as many of the newer private banks (like HDFC, ICICI) try to reach beyond their traditional clients in the housing, consumer finance and blue-chip sectors.

This will require a set of smaller step reforms, designed to affect the incentives of bankers

in private and public banks. A first step would be to make lending rules more responsive to 50 Berger et. al. (2001).


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