The Mistry Committee catalogued in gleeful detail the restrictive tendencies of Indian regulators, principally the Reserve Bank, and the consequent underdevelopment of financial markets. Rajan was more patient, and spent some time trying to understand why the Reserve Bank is such a curmudgeon. It is not just the central bank; it is manager of public debt, which is so huge and issued by such bankrupt governments that no sensible investors would buy it. So financial markets have to be rigged, and the Reserve Bank does its best to rig them.

The market the Reserve Bank rigs most is the one for bank deposits. It has ensured the dominance of lumbering, slothful government banks, and doggedly prevented emergence of competition. These banks are depositories for worthless government debt, so they cannot be allowed to get into trouble. Faced with this necessity, the Rajan Committee has proposed allowing entry of banks that would have only local licences and would therefore remain small. Their proposed entry implies higher interest rates in small towns and villages; it would require the abandonment of the current informal fixing of closely similar interest rates by banks.

Thus, although it does not say so, the Rajan Committee is as convinced as the Mistry Committee that the dominance of government banks must end. But it has tried to find a more diplomatic and politically acceptable route to their demise, namely allowing thousands of small private banks to come up.

Those local, small-town and rural markets are not unserved; they are served just now by the government’s bugbear, the moneylender. He is the one who would face competition from the new local banks. Can they succeed against him? His fixed costs are minimal, his local knowledge is considerable, and because he gets no help from the government in realising bad debts, his assessment of risk is highly refined. There is no way the new banks can compete with him – unless they become he. The new-model banks can succeed only if the current moneylenders are allowed to set them up. The Rajan Committee does not say it, and one cannot even be certain that it has thought it. But if bank licensing is removed and local banks are freely allowed to be set up, moneylenders will will set them up. The Committee is thus, in effect, recommending a reversal of policy towards moneylenders: it is proposing their graduation into properly run, lightly regulated banks.

If the government permits these moneylenders-turned-banks, they will rapidly capture business in small towns and villages. The government banks may not mind that because they do not care for that business anyway. But the new banks will make good profits, and will saturate the markets they are allowed into. Then they will want to — they will need to — expand beyond their permitted areas. The Reserve Bank will not want to expose government banks to their competition, and will not give them broader licences. But money is fungible; indirectly, money from local banks will leak out of their areas and compete with money from the big banks in the lucrative big cities.

This is not to say that the experiment should not be tried. But it will only postpone, not prevent, the emergence of such private competition as government banks cannot face. Banks were nationalised by Indira Gandhi in a fit of absence of mind. That mindless decision has done incalculable harm, and has become unsustainable. Official committees, while trying to save government embarrassment, look for ways of avoiding this conclusion. But it cannot be avoided. Local banks will be only a palliative, not a solution. The government should work out the next step before it takes this one.

(Businessworld issue 22-28 April 2008)