Tuesday, September 12, 2006

Entry barriers in banking reflected in UWB episode

The typical bank has Rs.5 in equity capital and Rs.100 of assets. If things go wrong, losses exceed Rs.5 and the bank is bankrupt. Generally, when a bank goes bad, the managers are in a scramble searching for cash for the months prior to failure. So from the viewpoint of a buyer, a bankrupt bank is a troublesome entity to get into in terms of ownership. It likely has weak processes; the staff is demoralised; there is possibly corruption; the recovery value of the bad loans is hard to ascertain.

When UWB went bust in India recently, there has been a surprising phenomenon of a raft of buyers lining up to grab control! This is entirely unexpected. A Business Standard editorial correctly says that this remarkable phenomenon is caused by entry barriers in banking. It is hard to start a bank. It is hard to get permission to start a branch of a bank. So under these conditions, what does the rational entrepreneur do? Buy a dead bank, for the license value.

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