All statements and comments about the inexact nature of economic analysis and decision-making are being well proved by the on-going debate on bank consolidation.

Consider the following:

(a) The finance minister of the country goes on record that consolidation of banks is necessary to improve the competitiveness of Indian banks globally, to reduce systemic risks and to enhance financial stability.

(b) The Asia Pacific chief economist of Standard & Poor's (the 'famous' credit rating agency) writes as follows: "the capacity of the (Indian) banking system to increase its coverage of less profitable customer segments in pursuit of financial inclusion will be hindered by the relatively small size of banks, which implies that consolidation is a pre-requisite for effective inclusion."
Now, this 'well settled and agreed' view on bank consolidation has been jolted sharply (to say the least) by the strikingly unambiguous and categorical counter-view of the newly appointed deputy governor (till recently the CEO of a top public sector bank).

While the S&P chief economist says that consolidation and getting bigger is a necessary condition for achieving financial inclusion, the deputy governor completely rebuts that view point. He argues that financial inclusion has to come first with
the existing infrastructure and organizational structure. Bank consolidation can be debated, he says, at a much later date after financial inclusion has been achieved. According to the deputy governor, it is not a settled case for bank consolidation even at a later date; it can only be debated, he says.

As for the deputy governor's views vis-à-vis the finance minister's, the dissonance is clear here also. While the finance minister feels that financial stability will be enhanced by consolidation, the deputy governor's views imply that stability can be achieved through greater financial inclusion. Consolidation is not that important in the overall scheme of things at present, says the deputy governor.

Can there be more strikingly different view points on a single issue? Probably not.

Going beyond variance in views …

The more important point here is to go beyond the variance in views which, after all, appears to be quite endemic to the discipline of economics itself and look at the real issues thrown up by this debate.

Let us take the finance minister's observation about consolidation improving the competitiveness of Indian banks globally. What is the competition in the global banking arena the finance minister is talking about? Because Indian banks have not covered fully the domestic market itself and created bigger balance sheets. An overseas foray, or more generally, an entry into a new business territory & is considered by any company only if its existing catchment area is saturated, fully exploited and the scope for expanding the existing overall market pie is nil.

Let us take the Finance Minister's observation about consolidation improving the competitiveness of Indian banks globally. What is the competition in the global banking arena the Finance Minister is talking about? Indian banks have not reached out to the domestic market itself and created bigger balance sheets. An overseas foray or an entry into a new business territory is considered by any company only if its existing catchment area is saturated, fully exploited and the scope for expanding the existing overall market pie is nil.

Can we say that about the Indian banking market? Have Indian banks completely covered the local market for the basic banking products such as deposits and loans? Have Indian banks completely covered the domestic market for other banking services such as funds transfers, remittances, etc?

This is the point the deputy governor has highlighted with the statistics that only 20 per cent of the Indian population have access to bank credit or that more than 60 per cent of the population do not have access to any kind of banking service. This data is an indictment of the country's prevailing level of financial exclusion indicating how much more ground banks need to cover domestically. It is not surprising, therefore, to note in this backdrop that overall bank credit forms only around 50 per cent of GDP in India, much lower than even in many emerging market economies such as Thailand or Korea and the top 50 urban centers account for close to 75 per cent of all bank deposits / credit.

(High and rapid credit growth does present its problems, as has been seen in the two countries mentioned above. The real issue is about the Indian banking system; it does not seem to possess the infrastructure, not only physical, for extending credit or other banking services to large sections of the unbanked population. Whether they actually extend credit / other services could be more a function of the official credit / monetary policy stance at any point in time).

Where is the question of competing globally in this scenario? There is so much work to be done back home.

Does size reduce systemic risk and enhance stability?

The other important point made by the finance minister is about consolidation reducing the risks to financial stability.

Now, a critical lesson from the great financial crisis of 2007-08 (and 2009?) is that size does not necessarily enhance stability. On the contrary, size poses the greatest systemic risk and creates the highest level of instability in the financial system. The depredations, no less caused to the broader economy itself by larger financial institutions such as a Citigroup, Lehman Brothers or AIG - with their complex inter-connected-ness and linkages to diverse segments of the financial system, are now legendary. Too big has indeed failed dismally. (Official reform in the US contemplates preventing the emergence of such large, complex institutions in the future).

In this backdrop, for somebody to argue that size and consolidation enhances stability is plainly ignoring the obvious. Indeed, one of the main factors identified as behind the relative stability in the financial systems of emerging market economies in the past 18 months – as the global crisis raged – has been their (EMEs) not going the way of the US or the UK in creating mega financial institutions with complex business lines and high leverage. Why should we, therefore, go for a model which has failed completely and which is being sought to be reformed even where it originated?

The need and even criticality of different kinds of financial institutions – (a) broadly banks and non-bank but credit creating institutions and (b) numerous players within a particular category of financial institution which will ensure that the failure of one does not cascade into a system-wide crisis and where other players can take the place of the failed institution(s) –
has been amply highlighted by the global financial / credit market crisis of 2007-08.

The need for diversity in the make up of the financial system is even more relevant in the Indian context. This is clearly evidenced by the low level of penetration of the main line banking services as pointed out by the deputy governor. Savings and credit are the life blood of any market based economy and we need a diverse range of institutions - short-term, long-term, banks and non-banks, local and regional banks, and micro finance institutions, to do the job.

The imperatives in India are to build on the foundation of a well-spread bank branch network and a conservative regulatory framework which has insulated India from global shocks. There are certainly other lessons to be learnt and global (finan-cial) ideas, products, instruments and market practices which need to be absorbed into the Indian system to enhance its effectiveness. But creating large, consolidated financial institutions is certainly not one such financial idea.