Deregulation, ownership, and productivity growth in the banking industry: evidence from India.

THE BANKING INDUSTRY in most economies has historically been much more regulated than other industries. Unlike other industries, the collapse of banks can have economy-wide repercussions as the payments system gets disrupted. Such regulation has been all the more stringent in developing economies

where controls on banking activities have been imposed to meet social and economic objectives of development. Thus, not only have there been strict controls on interest rates, there have also been stringent regulations relating to branch licensing, directed credit programs, and mergers (Caprio, Atiyas, and Hanson 1997).

Over time, however, the banking systems of many developing economies exhibited poor performance, and such under-performance was seen by many as the direct result of excessive regulations that were in place. Thus, starting in the 1980s, a large number of these economies undertook massive liberalization of their banking sectors to make them more productive and efficient. To a large extent such liberalization was influenced by the experience of developed countries, notably the U.S., where relaxation of regulations was found to be a major cause of productivity and efficiency increase in the airline industry (Morrison and Winston, 1995, Borenstein, 1992), the telecommunications industry, and the trucking industry (Winston 1993). Similar findings were also reported in a variety of industries in the Eastern and Central European economies (Dittus, 1994, Catte and Mastropasqua, 1993, Thorne, 1993, McKinnon, 1991).

The experience of deregulation with respect to the banking sector has, however, been mixed. For example, empirical studies with respect to the U.S. show that measured cost productivity actually decreased following deregulation (Berger and Mester, 2001, Humphrey and Pulley, 1997, Bauer, Berger, and Humphrey, 1993). Berger and Mester (2001) estimate that cost productivity worsened by 4.2% annually over the period 1984-91, and by as much as 12.5% annually during 1991-97. Increased competition following deregulation made banks transfer some of the market power back to the depositors in the form of higher interests on deposits, which increased banks' cost of funds. At the same time, reduction in operating costs through pruning the number of branches did not materialize as banks moved to provide convenient branching to depositors as a strategy of maintaining their market share (Humphrey 1991). Thus, measured cost productivity declined following deregulation though the unmeasured "quality" of banking output in terms of extensive branching and ATM networks, and a wider variety of financial services that helped customers better manage risks, may have well increased subsequent to deregulation (Berger and Mester, 2001, Humphrey and Pulley, 1997, Bauer, Berger, and Humphrey, 1993). This increase in quality was probably reflected in the significant rise in profit productivity (4.3% annually during 1988-91 and 12.2% annually during 1991-97) as banks increased their revenues through higher prices to endogenize the cost of higher output quality (Berger and Mester 2001).