When small banks create big risks

When Small Banks Create Big Risks Shishir Priyadarshi, President, Chintan Research Foundation Executive Summary: Ongoing supervisory actions in the urban cooperative banking sector signals a timely opportunity to deepen regulatory effectiveness and modernise institutions for a more resilient banking ecosystem.

The Reserve Bank of India’s recent restrictions on the Gauhati Cooperative Urban Bank-including limits on withdrawals and lending-are only the latest reminder that India’s urban cooperative banking sector remains a weak link in the financial system. Over the past few years, similar curbs have been imposed on institutions such as the New India Cooperative Bank in Maharashtra, the Maharashtra State Cooperative Bank, and several smaller urban cooperative banks across states. Earlier, in 2019, the collapse of the Punjab and Maharashtra Cooperative (PMC) Bank had already exposed the devastating consequences of prolonged supervisory blind spots.

Each episode follows a familiar pattern. Supervisory concerns surface, restrictions are imposed, depositors panic, and assurances are issued that the problem is “contained”. Yet the frequency of such interventions suggests that these are not isolated accidents. India's cooperative banks may be small individually, but collectively they serve millions of depositors and play a critical role in financing small traders, self-employed workers and micro-enterprises. Sustained stress in this segment is therefore not a marginal banking issue; it is a systemic challenge that deserves deeper scrutiny.

A structural problem, not episodic mismanagement

The temptation after every crisis is to blame a few errant managers or local political interference. While governance failures are undeniable-as seen starkly in PMC Bank’s undisclosed exposure to a single corporate group-they are better understood as symptoms of a flawed institutional design rather than exceptions to an otherwise sound model.

Many cooperative banks continue to suffer from politicised boards, weak internal controls and limited professional management. Fit-and-proper norms exist, but enforcement that used to apply to commercial banks, has historically lagged. Even today, accountability mechanisms are weaker, and management failures rarely attract consequences proportionate to the damage inflicted on depositors.

Regulatory asymmetry has compounded these vulnerabilities. For decades, cooperative banks operated under a dual-control structure, with state governments overseeing management while the RBI regulated banking functions. Although legislative changes have expanded the RBI's powers, legacy constraints persist. Under the new approach, the central bank resorts to cancelling the licenses of banks that undertake unscrupulous activities. There has been a steady increase in the number of banks losing their licenses since the pandemic, as represented below (fig. 1). The central bank can now identify a case of stress earlier-as in the cases of the New India Cooperative Bank or the Gauhati Cooperative Urban Bank-but its ability to force timely restructuring, overhaul boards, or execute swift resolution remains limited by the cooperative framework itself.

Business model pressures add another layer of fragility. Cooperative banks tend to have geographically concentrated loan books, making them vulnerable to local economic downturns. Their access to capital is constrained, technological adoption is uneven, and competition from small finance banks, public sector banks and fintech platforms has intensified. In effect, cooperative banks are being asked to operate in a modern, competitive banking environment without the balance-sheet strength, governance depth or regulatory clarity required to do so safely.

 

The broader economic cost of repeated failures

The damage caused by these failures extends well beyond the affected institutions. Each time withdrawal limits are imposed-as they were in the PMC Bank or more recently in smaller urban cooperative banks-depositor confidence takes a hit across the sector. Deposit insurance offers theoretical protection, but in practice, payouts are slow, and trust is lost instantly. For many households, especially retirees and small savers, the experience leaves a lasting scar.

Unscrupulous activities in urban co-operative banks are a huge drain on the government's reserves as well. All NPA’s are paid from the taxes that could otherwise be utilised on welfare and development activities. Among all types of co-operatives, urban co-operative banks record the largest write-offs of NPA, as depicted below (fig. 2).

Credit delivery also suffers. Cooperative banks are often the first formal lenders to small businesses and self-employed workers. When operations are curtailed, local credit dries abruptly, rendering these borrowers as the first casualty. Unlike larger firms, they cannot easily migrate to alternative lenders. The result is a sudden tightening of liquidity at precisely the level of the economy that is most sensitive to shocks.

Perhaps most concerning is the impact on financial inclusion. Repeated cooperative bank crises risk undoing years of progress in formalising savings. When smaller banks are seen as unsafe, households may retreat to cash holdings or informal finance, undermining both financial stability and policy transmission.

What meaningful reform must address

India does not need to abandon urban cooperative banking. These institutions have historically filled the gaps left by larger banks. But preserving their social role requires confronting uncomfortable truths.

First, governance reform must precede all else. Professional boards, transparent appointments, strict tenure limits and real accountability for management decisions are non-negotiable. Without this, capital injections or regulatory forbearance merely defer failure.

Second, the regulatory framework must become more graduated and risk-based. Larger, deposit-heavy urban cooperative banks should face supervision compared to those applied to commercial banks. Smaller institutions that lack scale should be encouraged to consolidate or adopt narrower, clearly defined business models. Mergers must be genuine restructurings, not cosmetic exercises that carry old problems into larger entities.

Third, India needs to strengthen its resolution mechanisms, and not just supervision. Faster depositor payouts, clearer communication during regulatory action, and transparent exit pathways for unviable banks would reduce panic and moral hazard. Prolonging the life of chronically weak institutions in the name of social objectives ultimately imposes higher costs on depositors and the economy.

What should be avoided are blanket bailouts and excessive regulation that accelerates failure without building capacity. The objective should be to build a cooperative banking sector that is smaller, stronger and more credible.

A forward-looking test of credibility

The RBI deserves recognition for its increasingly proactive stances. Early intervention in recent cases contrasts with the prolonged inaction that preceded the PMC Bank collapse. But supervision alone cannot compensate for structural flaws. As long as governance remains politicised and resolution uncertain, restrictions will continue to arrive after confidence has already been damaged.

India now faces a clear choice. It can either continue to manage cooperative bank crises episodically, or undertake a decisive reset of the sector's institutional foundations. The latter would protect depositors, stabilise local credit markets, and reinforce the credibility of financial inclusion.

If India aspires to be a resilient financial system that supports broad-based growth, it must stop viewing urban cooperative bank failures as unfortunate exceptions. It should treat them as warning signals. Ignoring them risks turning small banks into a recurring source of big economic risk.

The writer is President of the Chintan Research Foundation and former Director of WTO, with extensive experience in international trade, finance, and industry.; views are personal