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RBI governor Raghuram Rajan recently promised banking reforms, which includes more operational freedom for foreign banks if they adhere to some conditions. If Rajan can deliver on his promise, the impact will be significant as Indian banking needs more competition. A more competitive banking sector will translate into economic gains and provide access to the organised financial sector for more people.

Presently, Indian banking packs a lot of inefficiency, which is passed to consumers in terms of higher costs. Enhanced competition in any business will result in declining profitability as the opportunity to make easy money disappears. Banks here however have largely maintained their profitability over the last decade, suggesting that the 154 commercial banks hardly push each other. Compare Indian banks’ profitability with the UK and what comes through is that customers here are paying the price for inadequate competition. In 2012, Indian banks’ relative operating cost was higher than that of the UK. Despite this, Indian banks’ profitability was higher, indicating customers picked up the tab for inefficiencies.
 
RBI will face a backlash from different interest groups for promising foreign banks greater operating freedom. Hopefully, the blowback will be ignored as customers have all along paid the price for this protection. If anything, the fact that the controversial microfinance institutions were booming in south India, the region with the deepest banking penetration, showed that banks were unable to reach vast sections of the population. The similarities among public sector banks, which control a little over 70% of the sector’s assets, has partly contributed to the lack of competition. Foreign banks in India have been a beneficiary of this protected environment, with their profitability here far exceeding what’s possible in their home markets.
 
Issuing new bank licences in India seems to have become once-in-a-decade affair. Rajan shouldn’t stop with the current round of licenses, but pursue some of RBI’s own ideas on keeping licensing open all the time for applicants who meet the prescribed standards. There’s no convincing reason why bank mergers should trigger apprehension. Persistence of an environment that restricts competition should be the only taboo. Also, Rajan shouldn’t lose sight of other financial sector reforms he promised the day he took office. Given the liquidity problems small companies face, this is the right time to deliver on his promise that new instruments to help them would be introduced. Reforms mustn’t be delayed any longer.