The Case for Small Banks in India

By Suyash Rai, IFMR Finance Foundation

In what could become a welcome trend, the RBI has started putting out detailed discussion notes on future policy steps. Recently, the central bank released a discussion paper presenting the pros and cons of various approaches to new bank licenses . Though the paper doesn’t clearly favour any particular structure, it does seem to be tilting towards or away from certain possibilities. One possibility that the paper seems to be almost squarely opposed to is of allowing more small banks to be set up in the country. The paper lays out some arguments opposing the idea of small banks, and cites experience with small banks like local area banks and urban cooperative banks to make a case against them.RBI Bank India

As far as performance of local area banks is concerned, the record in itself doesn’t prove that the small banks don’t stand a chance. The Indian experience with such banks has been a mixed one, and there are examples of well performing banks in almost every category of small banks (local area banks, district credit cooperative banks, urban cooperative banks, etc), as there are of non-performing ones. This is true for big, national banks as well.

This process is inherent to the process of development of institution-types, and the key is to ensure learning and application of “design principles” that make banks successful, rather than writing off entire categories of institutions. If there are indeed inherent weaknesses in the model, which are unmanageable, then the model should very well be discarded. If there are advantages in the model, and weaknesses that can be managed by some structural innovations, then there is no real need to discard the small banks model itself.

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