India-EU free trade agreement: Rethinking banking services liberalization

India's policy makers should seriously reconsider the provisions in the country's proposed free trade agreement with the European Union which require it to open up its banking sector, says Kavaljit Singh.

SINCE 2007, India and the European Union (EU) have been negotiating a free trade agreement (FTA) - covering trade in goods and services, investments, intellectual property rights and government procurement - that is fraught with problems. Till now, 10 negotiating rounds have been held. The agreement is expected to be finalised by mid-2011.

One of the major underlying themes in the ongoing negotiations is the liberalisation of trade and investment in banking services. With the help of the FTA with India, the EU is seeking greater market access and export gains for its banks through cross-border supply and direct investments. Some of the key demands emanating from Europe include removal of all barriers to market access (commercial presence, cross-border supply and consumption) and grant of national treatment commitments.

The EU banks and powerful lobby groups such as the European Services Forum (ESF) have put forward a slew of demands including removal of all restrictions pertaining to branch licences, foreign ownership (of both public and private banks), numerical quotas, equity ceilings, differential taxation, and voting rights. The ESF is seeking removal of priority sector lending on locally incorporated EU-owned banks besides removal of current restrictions under which branch licences may be denied if foreign banks' aggregate share of the banking market exceeds 15%.

Another key demand of the ESF relates to the removal of restrictions on foreign banks' participation in exchange-traded commodity products. The ESF has also demanded free access to deposits made by state-owned companies.

By asset size, six out of the top 10 foreign banks in India are EU-based. The 9 EU-based banks together controlled 65% of total assets of foreign banks in India in 2008. Hence, the policy implications of opening up the Indian banking sector under the India-EU FTA would be markedly different from other FTAs such as the India-Singapore Comprehensive Economic Cooperation Agreement.

The burgeoning financial services trade

Though there are 27 member states of the EU, the banking services agenda is aggressively pushed by the UK and Germany. The UK is one of the leading centres for global banking, with the largest share of cross-border bank lending (18%) in the world. Financial services alone account for 8.3% of its GDP.

The UK remains the leading exporter of financial services in the world. According to estimates by the industry organisation IFSL, the UK's financial sector net exports were 41.8 billion in 2009 despite the global financial crisis. Banks were the largest single contributor, with net exports of 25.3 billion. The bulk of UK banks' net exports were generated through spread earnings (10.6 billion), with the largest contribution by derivatives.

In terms of the UK's balance of trade in goods and services in 2009, trade surpluses generated by financial services (40.2 billion) managed to partially offset large deficits in goods (82 billion). The UK's financial services trade surplus with India was 206 million in 2007, with banks contributing 197 million. Over the years, Germany and Ireland have also registered significant trade surpluses in financial services.

Tapping diaspora remittances

A number of Indian banks (especially big private banks) are also striving for an increased presence in Europe. It is interesting to note that Indian banks are not aiming at capturing the highly competitive domestic banking markets in Europe. Rather their aim is to tap the non-resident Indians (NRIs) based in EU member states. Since India is the largest remittance recipient country in the world ($55 billion in 2010), Indian banks are keen to serve this lucrative business segment by increasing their presence in the European banking markets.

Of late, some domestic banks have also been facilitating the acquisition of European companies by big Indian corporations. For instance, ICICI Bank co-financed United Spirits' takeover of Scotch whisky distillers, Whyte & Mackay, in 2007 and Tata Motors' $2.3 billion takeover of Jaguar and Land Rover in 2008.

The lure of niche banking markets

The motives behind EU-based banks entering Indian banking markets are obvious due to the immense profit opportunities and a stable banking system. For London-headquartered Standard Chartered, India became the largest contributor to the bank's global operating profits in 2010. The bank's profits in India reached $1.2 billion in 2010. For UK-based HSBC Holdings, Europe's largest bank by market capitalisation, India was the seventh largest contributor to its global profits in 2008.

By and large, European banks are interested in serving three niche market segments in India: upmarket consumer retail finance, wealth management services and investment banking. Several European banks (such as Societe Generale and BNP Paribas) are keen to expand their presence in niche markets such as private banking. The big-ticket mergers and acquisitions (particularly in the cross-border segment) taking place in corporate India require investment banking, underwriting and other advisory services where big European banks have a competitive edge over domestic banks.

The urban-centric European banks

To date, most of the branches of EU-based banks are located in metropolitan areas and major Indian cities where the bulk of the premium banking business is concentrated. As of March 2010, there were nine EU-based banks operating in India with a network of 213 branches. Out of these, 163 branches (76.5%) were located in metropolitan areas, 45 (21%) in urban areas and merely five  (2.3%) in semi-urban areas.

It is distressing to note that EU-based banks have not yet opened a single branch in the rural areas. This is despite the fact that several EU banks have been operating in India for more than 150 years. Established in 1858, Standard Chartered Bank is the oldest foreign bank in India. BNP Paribas and HSBC began their operations in India in the 1860s.

Not surprisingly, European and other foreign banks are not serving the poor and low-income people residing in metropolitan and urban areas. There is no regulatory ban on foreign banks serving the urban poor and low-income people.

The extent of financial exclusion in India

In India, financial exclusion has strong linkages with poverty and is predominantly concentrated among the poor and marginalised sections of society. Various studies have measured the extent of financial exclusion in India. The National Sample Survey Organisation of the Ministry of Statistics and Programme Implementation carried out the All India Debt and Investment Survey (AIDIS) 2002-03 to assess the indebtedness of Indian farmers. The Survey revealed that 45.9 million farmer households in the country (nearly 51%) do not have access to credit, either from institutional or non-institutional sources.

One of the negative consequences of banking sector reforms is the decline in bank branches in rural areas even though the total number of bank branches in India has increased. The total number of bank branches of all scheduled commercial banks (including regional rural banks) increased from 72,752 at end-June 2007 to 76,518 at end-June 2008 but the share of rural branches declined to 40.7% at end-June 2008 from 42.1% at end-June 2007. In 1991, the share of rural branches was the highest (58.5%). In other words, the recent spurt in bank branches has worsened the rural-urban ratio.

In August 2005, the Reserve Bank of India issued a list of 391 underbanked districts in India with population per branch more than the national average of 16,000. The underbanked population is higher in the north-eastern and eastern regions.

Since the 1990s, the banking sector has witnessed a secular decline in agricultural credit. This is in sharp contrast to the 1970s and 80s when a significant shift in bank lending in favour of the agricultural sector took place. The state-owned banks contributed 77.3% of total credit to agriculture at end-March 2007 while the remainder was contributed by the private sector and regional rural banks.

Besides, there has been a significant decline in bank lending to small- and medium-sized enterprises (SMEs) since the 1990s. The SMEs account for almost 40% of India's total production and 42% of exports and are the second largest employer after agriculture. The SMEs produce over 8,000 value-added products and are involved in several services sectors.

The exclusive banking model

Since European banks have no branches in the rural areas, they are not obliged to serve the vast sections of rural households who are excluded from the formal banking system. Their contribution in the opening of 'no frills' bank accounts under the financial inclusion programme has been abysmal.

Typically, foreign (and big domestic) private banks are averse to providing banking services to the poor because they find such clients less lucrative.

In particular, foreign banks tend to follow 'exclusive banking' by offering services to a small number of clients. Several EU-based banks and their lobby groups have expressed their discomfort in fulfilling the mandatory priority sector lending requirements. Rather they prefer a niche banking model with no riders in terms of social and developmental banking.

It is well established that not only do foreign banks in India charge higher fees from customers for providing banking services, but maintaining a bank account requires substantial financial resources. Given the fact that the average upmarket retail banking customer can be 10 times more profitable than the average mass-market retail customer, it is highly unlikely that the commercial interests of European banks would match the developmental needs of the unbanked population. Rather the liberal entry of European banks may constrict access to banking services in the country: geographically, socially and functionally.

Some pertinent questions

In the context of the proposed India-EU trade agreement, the following questions need to be put before the trade negotiators:

Will European banks augment the reach of the banking system to millions of Indian citizens who do not have access to basic banking services? Will EU-based banks undertake social and developmental banking? Can European banks meet the targets of financial inclusion for rural households, as suggested by the Committee on Financial Inclusion? Would European banks open their branches in low-income neighbourhoods? What extraordinary services would European banks provide to serve the unbanked population? What specialisation and experience do European banks have when it comes to providing basic banking services to landless rural workers and urban poor dwellers?

The fallout of the global financial crisis

Several European banks had acquired US-based mortgage and 'toxic' financial assets whose value plummeted sharply during 2007-08. This contributed to a sudden loss of confidence within the European banking system as banks became reluctant to lend to one another, thereby causing a dramatic loss of liquidity.

The highly leveraged EU-based banks (particularly in the UK, France, Germany and Ireland) sought billions of euros of state help to rebuild their balance sheets battered by the financial meltdown.

The European governments provided more than _3 trillion through guarantees and recapitalisation schemes to save the ailing banks. Since the financial crisis badly infected the real economy, the EU economies are not out of the woods yet as there are renewed worries about rising unemployment.

Post-crisis, serious questions have been raised about the strength and credibility of European banks. The global financial crisis has put a big question mark around their efficiency, 'best practices' and state-of-the-art risk management models. The crisis has also exposed the poor corporate governance and transparency norms of several European banks.

Given the higher degree of interconnectedness among EU banks, problems in one country quickly put the entire financial system at risk. Without doubt, the EU is facing unprecedented challenges in maintaining financial stability and strengthening banking regulations.

In contrast, the Indian banking system has largely remained insulated from global turmoil thanks to the limited presence of foreign banks, negligible exposure of domestic banks to US sub-prime markets and related financial instruments, and enlarged state ownership of the banking system. Often criticised as 'inward-looking' and 'conservative', India's regulatory framework also acted as a key determinant in protecting the domestic banking system from the global financial turmoil.

Rethinking the benefits and costs of banking sector liberalisation

The proponents of banking services liberalisation tend to overlook the potential costs associated with the entry of foreign banks into host countries. If the entry of foreign banks is allowed through acquisition of domestic banks, it may lead to a concentration of banking markets and loss of competition.

The foreign banks can be a source of cross-border contagion from adverse shocks originating elsewhere. A large presence of foreign banks from crisis-ridden countries could lead to rapid transmission of financial shocks to the host countries.

The parent bank may also reduce exposure in a host country or move out completely due to losses suffered in home or other countries. Post-crisis, foreign banks have drastically reduced lending in India. During 2009-10, the loan portfolio of foreign banks contracted by 9.7%. The UK's Royal Bank of Scotland has decided to exit from or shrink its operations in 36 countries (including India and China) due to problems at its parent bank.

In addition, it is highly debatable whether foreign banks' presence has a stabilising role in the event of a systemic crisis. In Argentina, for instance, several foreign banks chose to leave the country when a financial crisis erupted in 2001.

Furthermore, the entry of foreign banks poses new challenges to regulation and supervision. The regulatory and supervisory authorities are restricted to within their national borders while foreign banks can easily cross national borders and operate internationally. The overall responsibility for the parent bank remains with the regulatory authorities in the home country. But there is little coordination and sharing of information among the regulatory authorities of home and host countries.

The global financial crisis has proved beyond doubt that increased financial integration can transmit financial shocks across countries. Financial innovation in certain unregulated products and markets can also augment financial shocks. The crisis has highlighted the risks associated with the presence of large financial conglomerates in the domestic banking system. Post-crisis, several proposals for enhanced regulation and supervision of financial conglomerates (which operate in different segments such as banking, insurance, securities and private equity) are under consideration at various levels.   

Keeping these new developments in view, the policy makers should rethink the benefits of opening up banking services under the framework of the India-EU FTA.                               

Kavaljit Singh works with Madhyam (www.madhyam.org.in), a New Delhi-based policy research institute which addresses finance, trade and development issues. This article is an excerpt from a Briefing Paper published by Madhyam.

*Third World Resurgence No. 248, April 2011, pp 8-10