Articles : January 2010

By Pradeep S Mehta

The Finance Minister has said that bank consolidation will be left to the banks themselves rather than be pushed by the Government. This appears to be a response to the Prime Minister’s honorary economic advisor, Dr Raghuram Rajan’s who opined that public sector bank mergers are a not smart thing to do as a top down exercise, but to leave it on the bank boards to. On the other hand, the Reserve Bank of India (RBI) is reported to have suggested that bank merger regulation be exempted from the purview of the Competition Act, 2002, an issue which was also recommended by the joint Ministry of Finance-RBI Committee on Financial Sector Assessment in March, 2009. The jury is still out and the question is whether the banking sector should be exempted from the merger regulation of the Competition Act.

RBI’s request is understandable, given that, a) the banking sector’s stability is critical for the whole economy; the origins of the current global crisis is testimony enough, and b) there are too many banks in the public sector which need to be consolidated. These are two different issues and should not be confused. The whole debate has the potential of being derailed by misconceptions on the roles of the Reserve Bank and the CCI (Competition Commission of India). Arguments have been made that CCI does not have the expertise to regulate M&As in the banking sector, and that RBI has such expertise. This is not necessarily correct.

A distinction should be made between prudential regulation of banks by RBI and competition regulation of the whole economy, including financial sector, by CCI. Prudential regulation is largely centred on laying and enforcing rules that limit risk-taking of banks, ensuring safety of depositors’ funds and stability of the financial sector. Thus regulation of M&As by the RBI would be determined by such benchmarks. Competition regulation of M&As in the banking sector on the other hand is a different matter. This is aimed at ensuring that banks compete among themselves in fighting for customers by offering the best terms, lower interest rates on loans and higher interest rates on deposits and securities. Merger regulation by CCI would be therefore intended to ensure that such activities are not motivated by the desire to collude and make excessive profits at the expense of customers or to squeeze other players out of the market through abusive practices. While CCI does not have either the expertise or the remit on prudential regulation, RBI does not have the expertise or remit to regulate anticompetitive behaviour.

Competition in the banking sector improves access to finance for investment through lower interest rates for loans and lesser collateral requirements as banks fight for customers. Studies in the banking sector have found a negative relationship between an increase in the level of concentration and savings deposit rates. Studies have also found a positive relationship between an increase in concentration and an increase in interest rates and accompanying conditionalities. The role of switching costs in the banking sector need not be undermined; customers would continue to be tied to their banks due to the fixed transactional and informational costs needed to change a bank. It is therefore important to constantly expose banks to competition as they have an incentive to extract more rents from customers due to switching costs once they are dominant.

However, due to their core mandate of ensuring stability into the sector and security of depositors’ funds, central banks normally abhor intense competition among banks. Competition forces excessive risk taking as banks fight for customers, thereby compromising on security; hence there would be a trade-off with financial stability. This is also a lesson from the current global financial crisis. It is therefore important that both authorities are given space to exercise their mandates in the banking sector.

This also comes out of the best practices recommendation from the International Competition Network (ICN), the global association of competition authorities. The ICN calls for application of general competition rules to the banking sector by competition authorities in parallel to the rules enforced by the central bank. This practice is also followed by almost all countries with competition laws, save for few, but qualified, exceptions. These exceptions include Turkey, Italy, Brazil and the US.

In Turkey, the competition law is not applicable to the banking sector, but only if the total assets of the banks to be subjected to merger does not exceed 20 percent. In Italy, although the competition law applies to the banking sector, the provisions are enforced by the central bank. In Brazil, financial institutions are exempted from competition laws, and the central bank is expected to administer its own competition rules in the sector. This demonstrates the futility of entrusting a prudential banking regulator, largely focusing on stability, with a mandate on which it has no expertise. The US situation is also interesting; although banking mergers are exempted from competition laws, once the relevant agency (there are four of them, which includes the Federal Reserve) has approved a merger, the Anti-Trust Division of Department of Justice has a 30-day post approval period in which to file a suit to block the transaction. Parties are barred from consummating the merger once a suit is filed until a federal district court conducts a review of the transaction.

In the case of failing banks, unquestionably the mergers are allowed swiftly as happened in the case of Global Trust Bank in India, which was taken over by the Oriental Bank of Commerce in 2004. There can also be a one time exception from competition rules allowed in specific cases as happened in the UK in 2009 when Halifax Bank of Scotland was merged with Lloyds TSB after the earlier turned turtle, following the financial crisis.

There is room therefore for both CCI and RBI in the banking sector, and the economy stands to benefit if both are allowed to exercise their expertise. Genuine concerns such as the effects of delays from CCI in making decisions, especially in case of forced mergers should not be used as justification for total but rather conditional exemptions. Just like in other countries, CCI can timely handle M&As in the sector with no delays only if there is cooperation between RBI and CCI. The sooner the two regulators sit down and work out a cooperation agreement the better for the whole industry, and one hopes that this call for exemptions will not be a basis for an acrimonious relationship between the two.

The author is the Secretary General of CUTS International and can be reached at psm@cuts.org . Cornelius Dube of CUTS contributed to this article.

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