Indian Banking -Moving towards Globalisation

Bank Economists' Conference- [BECON-2003]


Bank Economists' Conference 2003 (BECON) was held in Mumbai on December 11-12. The theme of the conference was "Indian Banking -Moving towards Globalisation". In his inaugural address, Dr Y V Reddy, Governor, RBI, stated that Indian banking sector have won the respect and admiration of most observers. He pointed out that the global giants in banking all over the world are manned by Indians, educated and trained in India. The best of technology for the most sophisticated banks in the world is provided by Indian companies and by Indians in foreign companies.

Dr Reddy charted a roadmap towards achieving global standards. He underscored the need for a better payment and settlement systems, technology upgradation, flexibility of products. More importantly, he said, the success in adopting globalisation depends in managing the process of globalisation.

Globalisation : A Framework


The concept of globalization, in the sense in which it is used now, can be traced to the phenomenon of nation states. Government-imposed restrictions on movement of goods, services, people and capital are less than a hundred years old; in fact, passports and visas and the whole gamut of restrictions are a feature of the late 19th Century and the first half of the 20th Century. The nation state put restrictions on its citizens in their involvement with other nation states in what was perceived as the collective self-interest of its citizens. In the context of public policy relating to globalization, a critical issue is the trade-off between individual freedom and collective self-interest as also where the burden of proof lies, namely, with individuals or national authorities.

Globalisation has several dimensions arising out of what may be called the consequential enhanced connectivity among people across borders. While such enhanced connectivity is determined by three fundamental factors, viz., technology, taste and public policy, cross-border integration can have several aspects: cultural, social, political and economic. For purposes of this presentation, however, the focus is on economic integration. Broadly speaking, economic integration occurs through three channels, viz., movement of people, goods and services, and movements in capital and financial services.


The most notable achievement of recent globalization is the freedom granted to some, if not all, from the tyranny of being rooted to a place and the opportunity to move and connect freely. For example, many Indians relatively from poorer sections have benefited by developments in Middle East while many talented professions gained from movement to UK and USA. At the same time, in reality, there are several economic as well as non-economic, especially cultural or emotional reasons for people not globalising.

In regard to trade in or movement of goods and services across borders, there are two types of barriers, viz., what are described as natural and artificial. Natural barriers relate to various costs involved in transportation and information over distances. Artificial barriers are those that are related to public policy, such as, import restrictions by way of tariff or non-tariff barriers. The pace and nature of globalization will depend on the combined effect of technology and public policy, both at national and international levels.


In regard to capital movement also, the interplay between technology and public policy becomes relevant. There are, however, some special characteristics of capital flows. These characteristics have highlighted the issue of what is described as contagion, namely, a country is affected by developments totally outside of its policy ambit though domestic policy may, to some extent, determine the degree of vulnerability to the contagion. In any case, cross-border flows of capital have wider macroeconomic implications, particularly in terms of the exchange rate that directly affects the costs and movement of people as well as goods and services; the conduct of monetary policy and the efficiency as well as stability of the financial system. Furthermore, capital flows by definition involve future liabilities or assets and could involve inter-generational equity issues.

Developments in technology and innovation in financial services impact both domestic and cross-border transactions. The implications for public policy of such developments in the domestic area are on a different footing in the sense that domestic financial markets are in some ways subject to governmental regulation by national authorities while cross-border flows are not as susceptible to governmental regulation. Finally, in the context of cross-border capital flows, in the absence of procedures for dealing with international bankruptcy and facilities for the lender of last resort, the liabilities incurred on private account can devolve on public account. In brief, at this juncture, in respect of global economic integration through movement of capital, several risks devolve on domestic public authorities, especially in the case of developing countries.


Globalisation is a complex phenomenon and a process that is, perhaps, best managed by public policies. In managing the process, developing countries face challenges from a world order that is particularly burdensome on them. Yet, as many developing countries have demonstrated, it is possible for public policy to manage the process with a view to maximizing benefits to its citizens while minimizing risks. The nature of optimal integration, however, is highly country specific and contextual. On balance, there appears to be a greater advantage in well-managed and appropriate integration into the global process, which would imply not large-scale but more effective interventions by governments. In fact, markets do not and cannot exist in a vacuum, i.e., without some externally imposed rules and such order is a result of public policy.


The poor, the vulnerable and the underprivileged will continue to be the responsibility of national governments and hence of concerns to public policy. Sound public policies at the national level in countries like ours are very critical in the current context of levels of development and extent of globalization. In brief, it is necessary to recognize that nation-states, as those still primarily responsible for social order in the communities in which people live, have a duty to manage the process of globalization. This challenge is particularly complex in the area of financial services, more so in the case of banks in the larger emerging economies.


Globalisation in Context of the Financial & Banking Sector


At the outset, it would be useful to consider the emerging picture of financial flows as per the latest data released by IMF in the context of increasing globalisation. For almost all the years from 1999, the current account balance of advanced economies has been negative and it is estimated to reach US $ 225 billion in the year 2004 from a positive of US $ 41 billion in 1998. The developing countries, which had a current account deficit of US $ 83 billion in 1998, are estimated to have a surplus balance of a projected US $ 28 billion in 2004. It is interesting to note that while globalization is expected to result in flows of capital from developed to developing countries, it is not clear whether the turn arounds in the current account deficits is a temporary phenomenon. The removal or attenuation of cross-border barriers to trade and capital flows renders assessment of international financial flows that much more difficult to capture in the data.

It is also interesting to consider the pattern of net capital flows to emerging market economies. While private net direct investment has been consistently positive and above US $ 100 billion since 1995 to 2003, private net portfolio investment which was positive in the years 1995 to 1999 is since negative in the rest of the years. The range during 1995-2003 has been from a positive US $ 83 billion to a negative of US $ 53 billion. It is, thus clear that both in terms of magnitude and stability, private direct investment seems to have a significant edge over portfolio investment.


On the quality of capital flows, it is interesting to note that at the end of 1997, the estimated share of Off-shore Financial Centres in the total of cross border assets stood at 54.2 per cent, as per a recent study by OECD discussed in the G-20 meeting in Mexico. The study mentions that inadequate access to bank information in such centres greatly facilitates money laundering, smuggling of goods, counterfeiting and financing terrorism, etc. In any approach to the policies relating to the financial integration, it may be useful to keep these facts in mind, particularly both quantitative and qualitative factors in such flows, particularly in the context of the banking sector.


As already mentioned, there is an increasing recognition of a distinction between trade integration and financial integration and this distinction has been recognized forcefully in a recent study made a few months ago by the IMF. The summary of the study reads as follows:


"The empirical evidence has not established a definitive proof that financial integration has enhanced growth for developing countries. Furthermore, it may be associated with higher consumption volatility. Therefore, there may be value for developing countries to experiment with different paces and strategies in pursuing financial integration. Empirical evidence does suggest that improving governance, in addition to sound macroeconomic frameworks and the development of domestic financial markets, should be an important element of such strategies. It might not be essential for a country to develop a full set of sound institutions matching the best practices in the world before embarking on financial integration. Doing so might strain the capacity of the country. An intermediate and more practical approach could be to focus on making progress on the core indicators noted above, namely transparency, control of corruption, rule of law, and financial supervisory capacity…….."


Apart from this interesting research on the subject, on a judgemental basis, considering the cross-country experiences, it is possible to discern some disconnects between impressions and reality. Though many developing countries have adopted significant policy measures for financial integration with the rest of the world, capital flows both foreign direct investment and portfolio investment, are predominantly accounted for by a few countries which are not very high in terms of financial integration with rest of the world. In other words, de jure financial integration seems to be distinct from de facto integration. Furthermore, the way the financial markets as well as international financial institutions respond to economies requiring adjustment problems appear to be asymmetrical. The financial markets, in fact, tend to be far more pro-cyclical in the case of the emerging economies, thus making emerging economies subject to greater volatility in flows than the other countries. It is essential to recognise that the capacity of economic agents in developing economies, particularly poorer segments, to manage volatility in all prices, goods or forex are highly constrained and there is a legitimate role for non-volatility as a public good.


Globalization and the Banking Sector

It is in this overall scenario, the policy relating to the financial services, and in particular banking, must be considered. It is interesting to note that WTO negotiations on financial services have been cautious and the commitments of many larger economies in the banking sector are rather particularly limited. In other words, in the context of issue of national ownership of financial intermediaries, banks appear to have a unique place in public policy. There are several noteworthy features of ownership and control of banks in all major economies – irrespective of whether they are developed or emerging. In almost all cases, banks are either widely held or have substantial State ownership. Furthermore, there are special conditions governing the extent of ownership, the nature of ownership and control, and transfers of such ownership or control through statutory backing. These are justified since the banks are admittedly special. The discussions in WTO on Commitments relating to opening of domestic banking sector to foreign banks/ownership reflects these concerns in most of the major economies.


It is worth recalling what Sir Eddie George, the Governor of Bank of England had said on the subject banks being special: "they remain special in terms of the particular functions they perform - as the repository of the economy‘s immediately available liquidity, as the core payments mechanism, and as the principal source of non-market finance to a large part of the economy. And they remain special in terms of the particular characteristics of their balance sheets, which are necessary to perform those functions – including the mismatch between their assets and liabilities which makes banks peculiarly vulnerable to systemic risk in the traditional sense of that term." He is even more forthright in making it clear that treatment of banks can not be on par with non-banks. "On the other hand, I am not persuaded that the special public interest in banking activity extends to non-banking financial institutions, though different functional public interests in many cases clearly do."


Data clearly indicates that banks continue to play a pre-dominant role in financial intermediation in developing countries. This is understandable for several reasons viz. the savers’ eagerness for assured income; inadequate capacity to manage financial risks and the fact that the banking institutions in some sense and in different degrees, enjoy deposit insurance and either implicit or explicit guarantee of government.

It is important to note that banking crisis invariably results in heavy costs to the Government, whether they are publicly owned, privately owned, domestically owned or foreign owned. The fiscal costs of banking crises are ownership-neutral.

An important question in this context is whether the role of banks in financial integration in developed countries is different from that in the emerging market economies. It is useful to assess the significant differences in the structure of the banking industry in emerging vis-à-vis developed markets.


In most emerging markets, banks assets comprise well over 80 per cent of total financial sector assets, whereas these figures are significantly lower in developed economies. In most emerging market economies, the five largest banks (usually domestic) account for over two-thirds of bank assets. These figures are much lower in developed economies. Another difference in the banking industry in developed and emerging economies is the degree of internationalisation of banking operations. Internationalisation defined as the share of foreign-owned banks as a percentage of total bank assets, tends to be much lower in emerging economies. This pattern is, however, not uniform within world regions.

Finally, a significant feature of banking in developed versus emerging economies, especially in recent years, has been the process of consolidation. The most notable difference between the consolidation process in developed and emerging markets is the overwhelming cross-border nature of mergers and acquisitions in the latter. In particular, cross-border merger activity in continental Europe and also between US and European institutions has been more of an exception rather than the rule. In contrast, there has been a sharp increase in foreign ownership of some emerging market banks due to process of privatisation often associated with crises.


An important difference in this context has been the role played by the authorities in the financial sector consolidation process. In mature markets, consolidation has been seen as a way of eliminating excess capacity and generating cost savings to the institution. In emerging markets, on the other, consolidation has been predominantly a way of resolving problems of financial distress, with the authorities playing a major role in the process.