[sbinews] Universal Banking: The Road Ahead? (From Indiainfoline.com)

  • From: "Rajendra S. Pai" <rspai9@xxxxxxxxx>
  • To: sbinews@xxxxxxxxxxxxx
  • Date: Mon, 12 Apr 2004 20:18:59 -0700 (PDT)

Universal Banking: The Road Ahead?

Economic historians have long emphasized the
importance of financial institutions in
industrialization. More recently, economists have
begun more intensive investigation of the links
between financial system structure and real economic
outcomes. In theory, the organization of financial
institutions partly determines the extent of
competition among financial intermediaries, the
quantity of financial capital drawn into the financial
system, and the distribution of that capital to
ultimate uses. The choice between universal and
specialized banking may affect interest rates,
underwriting costs, and the efficiency of secondary
markets in securities. Furthermore, the presence or
absence of formal bank relationships may affect the
quality of investments undertaken, strategic
decision-making, and even the competitiveness of

Particularly since World War II, many economists and
historians have argued that German-style universal
banks offer advantages for industrial development and
economic growth. Universal banking efficiency combined
with close relationships between banks and industrial
firms, they hypothesize, spurred Germany?s rapid
development at the end of the nineteenth century and
again in the post-World War II reconstruction. A
corollary to this view holds that countries that
failed to adopt the universal-relationship system
suffered as a consequence. Adherents suggest that
British industry has declined over the past hundred
years or more, and that the American economy has
failed to reach its full potential, due to
short-comings of the financial system that lead to
relatively high costs of capital.

In Indian context, the phenomenon of universal
banking?as different from narrow banking?has been in
the news in the recently. With the last Narasimham
Committee and the Khan Committee reports recommending
consolidation of the banking industry through mergers
and integration of financial activities, the stage
seems to be set for a debate on the entire issue.

A universal bank is a ?one-stop? supplier for all
financial products and activities, like deposits,
short-term and long-term loans, insurance, investment
banking etc. Global experience with universal banking
has been varied. Universal banking has been prevalent
in different forms in many European countries, such as
Germany, Switzerland, France, Italy etc. For example,
in these countries, commercial banks have been selling
insurance products, which have been referred to as
Banc assurance or Allfinanz.

After the stock market crash of 1929 and banking
crisis of the 1930s, the US banned all forms of
universal banking through what is known as the Glass-
Steagall Act of 1933. This prohibited commercial banks
from investment banking activities, taking equity
positions in borrowing firms, selling insurance
products etc. The idea was to mitigate risky behaviour
by restricting commercial banks to their traditional
activity of accepting deposits and lending.

Research on the effects of universal banking has been
inconclusive as there is no clear-cut evidence in
favour of or against it anywhere. Nevertheless, the
United States has once again started moving cautiously
towards universal banking through the
Gramm-Leach-Bliley Act of 1999 which rolled back many
of the earlier restrictions. Some recent phenomenon,
like the merger between Citicorp (banking group) and
Travelers (insurance group) confirmed the fact that
universal banking is here to stay. Hence it becomes
all the more imperative to know whether we need
universal banks in India. And whether it is a more
efficient concept than the traditional narrow banking.
What are the benefits to banks from universal banking?
The standard argument given everywhere?also by the
various Reserve Bank committees and reports?in favour
of universal banking is that it enables banks to
exploit economies of scale and scope. What it means is
that a bank can reduce average costs and thereby
improve spreads if it expands its scale of operations
and diversifies its activities.

By diversifying, the bank can use its existing
expertise in one type of financial service in
providing the other types. So, it entails less cost in
performing all the functions by one entity instead of
separate specialized bodies. A bank possesses
information on the risk characteristics of its
clients, which it can use to pursue other activities
with the same clients. This again saves cost compared
to the case of different entities catering to the
different needs of the same clients. A bank has an
existing network of branches, which can act as shops
for selling products like insurance. This way a big
bank can reach the remotest client without having to
take recourse to an agent.Many financial services are
inter-linked activities, e.g. insurance and lending. A
bank can use its instruments in one activity to
exploit the other, e.g., in the case of project
lending to the same firm which has purchased insurance
from the bank.

Now, let us turn to the benefits accruing to the
customers. The idea of ?one-stop-shopping? saves a lot
of transaction costs and increases the speed of
economic activity. Another manifestation of universal
banking is a bank holding stakes in a firm. A bank?s
equity holding in a borrower firm acts as a signal for
other investors on the health of the firm, since the
lending bank is in a better position to monitor the
firm?s activities. This is useful from the investors?
point of view.

Of course, all these benefits have to be weighed out
against the problems. The obvious drawback is that
universal banking leads to a loss in economies of
specialization. Then there is the problem of the bank
indulging in too many risky activities. To account for
this, appropriate regulation can be devised, which
will ultimately benefit all the participants in the
market, including the banks themselves.

In spite of the associated problems, there seems to be
a lot of interest expressed by banks and financial
institutions in universal banking. In India, too, a
lot of opportunities are there to be exploited. Banks,
especially the financial institutions, are aware of
it. And most of the groups have plans to diversify in
a big way.

Even though there might not be profits forthcoming in
the short run due to the switching costs incurred in
moving to a new business.

The long-run prospects, however, are very encouraging.
At present, only an ?arms-length? relationship between
a bank and an insurance entity has been allowed by the
regulatory authority, i.e. the Insurance Regulatory
and Development Authority (IRDA). This means that
commercial banks can enter insurance business either
by acting as agents or by setting up joint ventures
with insurance companies. And the RBI allows banks to
only marginally invest in equity (5 per cent of their
outstanding credit).

Development financial institutions (DFIs) can turn
themselves into banks, but have to adhere to the
statutory liquidity ratio and cash reserve
requirements meant for banks. Even then, some groups
like the HDFC (commercial banking and insurance joint
venture with Standard Assurance), ICICI (commercial
banking), SBI (investment banking) etc., have already
started diversifying from their traditional activities
through setting up subsidiaries and joint ventures. In
a recent move, the Life Insurance Corporation
increased its stakes in Corporation Bank and is
planning to sell insurance to the customers of the
Bank. Corporation Bank itself has been planning to set
up an insurance subsidiary since a long time. Even a
specialized DFI, like IIBI, is now talking of turning
into a universal bank.

All these can be seen as steps towards an ultimate
culmination of financial intermediation in India into
universal banking.

Kamal Sehgal
(MBA 2002-04) IIFT

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