The contribution of banking, finance, and related segments to corporate profits in India is about one-third. On the other hand, the contribution to the gross value added (GVA) is closer to one-tenth. Estimates vary depending on the definitions and data sources but it may be said that the contribution of the broad sector to profits is at least three times its contribution to GVA in the economy! There is a stark difference. Why? And, what can be done about this?
The large profits in the broad financial sector are in the absence of any scams. And, the issue is even more serious if we also consider large bonuses, and various direct and indirect perks for the personnel in the industry. All this is not to say that investment in stocks in banks and the finance sector more generally is necessarily a good idea because the high profits tend to be already incorporated in stock prices.
In the primary market, not only do the investment bankers themselves gain substantially, they also facilitate the exit of others when stock prices are high. The others include the domestic and foreign promoters, private equity investors, and “angel” investors in non-bank and non-finance companies. If we include such gains as well, the disproportionate profits due to banking, finance and related segments are even more extraordinary.
Though there are issues of high profits in various areas like investment banking, insurance sector, credit card industry, non-bank finance companies, stock exchanges, and so on, the main analysis here is about commercial banks and financial markets. If all commercial banks are private, they can compete with each other. Similarly, if all banks are public sector banks (PSBs), again they can compete with each other though at a relatively low level. But if we have some PSBs and some private banks, then the former can find it difficult to compete and the latter can be highly profitable!
Clearly a body like the Competition Commission of India (CCI) can hardly increase competition between the two kinds of banks and thereby reduce the large profits of the private banks. But we can have a different approach. There can be two different ways of having a level playing field — privatise the PSBs, or nationalise the private banks.
There are reasons to believe that privatisation is better though it is, of course, important to ensure that this is carried out appropriately. This can increase the effective competition, and reduce what are very high bank profits at present. It may appear that the proposed policy solution for banks is politically difficult but this apprehension is not consistent with the somewhat smooth experience with the major economic reforms in India in 1991.
The making of profits
Let us now come to the financial markets. Large profits are made in various ways. The truly well-informed investors make good gains by reducing their exposure when the going is good in, say, the stock market. The less well-informed investors are left holding the bag directly or indirectly. They lose in many other ways as well. The gainers include also wealth managers, financial registrars, auditors, television and online channels, brokers, asset management companies, distributors, and operators of portfolio management schemes, and alternative investment funds.
It is true that in general, the more talented people earn more than the less talented people. However, in financial markets the returns for the “talented” participants are partly due to the participation of the financially less well-informed investors. And, the mistakes can get repeated time and again, though not always by the same people. Again, a body like the CCI cannot ensure greater competition and thereby reduce large profits.
What then is a policy solution for financial markets? The economics is actually simple though there is a need to overcome some vested interests, and, more important, some issues of the mindset. But before we consider the — out of the box — solution here, it will help to consider some analogies from elsewhere in the economy.
In the field of transport, only a licensed person can drive on roads, given the risk for the driver and for others on the road. In another field like medicine, patients usually buy non-routine medicines after a consultation with a licensed medical practitioner. In legal matters, typically it is a qualified lawyer who represents a client in a court of law. The point is that there are well accepted de-jure or de-facto restrictions in individual or social interest.
Seek consultation
We can now come to the policy solution for financial markets. We need a law under which it is mandatory for an investor to seek a consultation with a licensed financial advisor. Advice needs to be mandatory because many ordinary investors are not well aware that their knowledge of finance is actually deficient. Also, there is a need to improve the selection, education and licensing of financial advisors.
Finally, though the financial advice is mandatory under the proposed solution, an investor is free to accept or reject the advice.
Do people accept sound and independent advice? We know from fields like medicine, and even in a field like law that people usually do accept advice from professionals. This suggests, if not implies, that sound advice on a variety of financial matters will be, by and large, accepted by ordinary investors. Then they can gain, and profits for various segments of the financial sector can be relatively less.
It is not just a zero sum game wherein some lose while others gain though this matters in itself. Think also of the Lost Decade — in economic growth — in Japan after the bubble burst in asset markets in 1989-90. The implications for the economy are not always extreme but there can be costs in the aggregate.
To conclude, banking and finance are very useful. However, the profits are disproportionately high. This is due to the policy framework that is implicitly and inadvertently permissive of large persistent profits there. That basic policy framework needs to be changed.
The writer is an independent economist. He taught at Ashoka University, ISI (Delhi) and JNU
