This article explores the existence of ‘economies of scale’ in Indian banking industry using a simplistic approach proposed by Humphrey (1987). Presence of scale economies would indicate that banks would be improving in cost efficiency with increase in their asset size. Our results reveal that economies of scale are present both in public and private sector banks in India. However, when provisioning Non-Performing Assets (NPAs) are included in the analysis, the results are more dispersed, especially for the private sector banks. Nevertheless, a combined sample of public and private sector banks largely indicates a presence of economies of scale, even after including ‘provisions’ in the analysis. However, there are larger variations in the average cost of lowest and highest quartiles compared to average costs across bank size classes, these economies of scale will have little competitive impact relative to those competitive effects that already evidence due to higher variations in cost levels.

I. Introduction

Consolidation in Indian banking is in full swing. Government of India (GoI) has recently decided to consolidate 10 state-run banks into four megabanks. These are:

  1. Punjab National Bank (Oriental Bank of Commerce and United Bank of India are the merged banks)
  2. Union Bank of India (Corporation Bank and Andhra Bank are the merged banks)
  3. Canara Bank (Syndicate Bank is the merged bank)
  4. Indian Bank (Allahabad Bank is the merged bank).

This decision followed the previous successful merger of three state-run banks- Bank of Baroda, Vijaya Bank and Dena Bank to create India's third-largest bank then. In 2017, five associates of State Bank of India (SBI) and Bharatiya Mahila Bank were merged with SBI. The basic motivation behind these decisions was to create big banks to enable them to withstand any unforeseen shocks such as deterioration of asset quality and reduce operational expenses by experiencing scale economies. As per biannual Financial Stability Report (FSR), Reserve Bank of India (RBI), NPAs ratio in Indian banks reached 10.8 in September, 2018. To bear such a kind of pressure of deterioration of asset quality, GoI has felt that the consolidation of appropriate size mix of banks would be one appropriate solution along with other initiatives such as capitalisation of banks, improving loan recovery and bringing up of the Insolvency and Bankruptcy Code (IBC).

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