Needed: A hard policy reset to make Indian banks shape up

This doesn’t sit well with India’s image as a high potential tech-savvy economy. We need a highly efficient financial system to support India’s aspiration to be a ‘developed’ economy by 2047. A critical element of that is low intermediation cost—basically, the cost banks incur to connect savers and borrowers.

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India has had great success with national digital initiatives. The Unified Payments Interface, widely known as UPI, for instance, has become a global benchmark. The same energy is needed within banks. As Prime Minister Narendra Modi said: “Make in India. Make for the world.” If Indian banks innovate and improve productivity, they can be role models for the Global South, just as UPI is today in payments. To encourage this, India would need a fresh policy approach. Here is what could make the difference required:

First, welcome global interest in Indian banking with an attractive policy framework: India is one of the few large economies still growing fast. Global financial institutions are eager to enter and serve the Indian market. India should welcome this capital and capability with a policy that is attractive to institutions that enter India with an eye on long- term value generation. This will bring more technology, better services and stronger competition.

Second, re-invigorate competition with new bank licences: Competition drives innovation and efficiency. But India has only a few banks that operate at a reasonably large scale and market pressure to innovate is limited. The banking sector’s regulator has been very cautious in issuing new full-service bank licences.

In contrast, several Southeast Asian countries have introduced digital-only bank licences. Brazil supported fintech startups and now has NuBank—a successfully scaled fintech bank. India tried new formats like payment banks and small finance banks, but they haven’t delivered strong results. We need more full-service digital-savvy new banks in India to drive real change.

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Third, make digitization a policy priority: The banking sector in itself should not be seen as a tool for job creation. Instead, it should enable industry and services to grow, thus creating jobs. Over the last five years, Indian banks have hired huge numbers of new staff. High levels of staff attrition result in wasted costs and operating risks (given manual processes).

Instead, banks must aggressively embrace artificial intelligence (AI) to digitize operations, sales and customer service. AI and automation must allow customers to serve themselves easily, with bank staff stepping in only when needed. As in the accompanying data chart, our study shows how India has had the slowest growth in productivity among major economies in recent years (measured in terms of inflation-adjusted bank assets per employee). This is not what one would expect in a tech-driven sector.

Other data offers a clue: Indian banks spend the least on technology (measured by depreciation as a share of operating expenses). While this is not a perfect measure, it reveals low internal tech capability and high reliance on vendors.

This raises a key question: Shouldn’t digitization of India’s banking industry be a national policy priority? Should banks that invest in digital research and development (R&D) not get a tax incentive like the pharma industry gets? Should the regulator that monitors Indian banks not emphasize productivity enhancing digitization along with its emphasis on risks in its supervision?

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Fourth, introduce regulated back-end service providers for banks: Big banks have an edge because tech investments are expensive and easier to spread across a large business base. This leads to a market with a few large players, as small players find it difficult to be cost competitive.

If India wants more banks and more competition, we must allow for shared tech infrastructure to create synthetic scale for small and mid-size banks. Policy should permit regulated service providers to handle tech-intensive back-end operations for many banks.

Inspiration can be taken from the mutual fund industry, where registrars and transfer agents (regulated by the Securities and Exchange Board of India) serve all asset managers. This approach encourages back-end collaboration and front-end competition, and would enable many mid-sized banks to compete effectively.

Fifth, redefine what a bank can be: The traditional definition of a bank hasn’t changed in decades. Banks today are digitally connected to both consumers and businesses. They sit in a unique position to connect the two—helping small businesses find customers or large firms find suppliers. They can enable orders, manage reconciliation and process payments, creating new sources of revenue while improving the wider economy’s productivity. Current regulations don’t allow banks to play this expanded role. That needs to change. In a digital world, our conception of what a bank is should evolve.

For future-ready banking: India’s ambition to become a developed economy by 2047 demands a financial sector that is productive, competitive and digitally enabled. The banking sector must undergo a hard reset. With the right policy shifts—in competition, digitization, industry structure and innovation—we could build a banking system that supports high growth and serves as a model for the world.

The author are, respectively, global leader and director in BCG’s Financial Institutions practice.