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While globally `consolidation' is a strategic issue for
bank practitioners, in India, it has not progressed beyond
an inconclusive public debate due to the political sensitivity
attached to it. Unfortunately, economic theory too does
not give us a conclusive answer. It only provides the conflicting
predictions about the relationship between banking structure
and financial stability.
Let us first understand the arguments commonly made against
consolidation. Generally, the process of consolidation gives
rise to a few large banks, which possess greater degree
of market power. It has been observed that banks with greater
market power tend to charge high interest rates to corporates,
who, in turn, are forced to assume greater risks. Besides,
policy makers tend to favor large banks in a disproportionate
fashion through their "too big to fail" policies.
This tends to intensify risk-taking behavior amongst these
banks, increasing the fragility of the overall banking system.
Moreover, large banks/institutions are always more complex
and hence more `opaque'. This also increases the fragility
of the banking systems characterized by a few large banks.
On the other hand, the proponents of consolidation argue
that large banks always diversify better, and hence, banking
systems characterized by a few large banks will be less
fragile than banking systems with many small banks. Also,
large banks tend to earn higher profits, which provide a
`buffer' against adverse shocks and increase the franchise
value of the bank. Some feel that a few large banks are
easier to monitor than many small banks. The common example
given is that of the US system vis-à-vis the systems
in the UK and Canada. US, with its large number of small
banks, has a history of much greater financial instability
than UK or Canada, where the banking sector is dominated
by a few large banks.
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