Stop Blaming India’s Public Sector Banks

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Calls for privatisation of India’s public sector banks show a certain disregard for the nature of the banking sector in general, and the record of India’s own banking sector over the past two decades

A view of the State Bank of India's headquarters. Credit: Roshan Panjwani

A view of the State Bank of India’s headquarters. Credit: Roshan Panjwani

India’s public sector banks (PSBs) are reeling under the weight of non-performing assets. According to media reports, they have written off Rs 1.14 lakh crore of these assets in the years 2013-15. In the process, many banks have posted losses; others show a sharp decline in profit.

Outraged commentators and a section of the public ask why tax payers should pay for the alleged inefficiency of PSBs. They view the woes of India’s banking sector as the ‘aha’ moment in banking reform: it is time the government exited majority ownership in PSBs. Then- and only then- can the government save the fisc from being mauled by repeated ‘bailouts’ of banks.

This line of thinking would, perhaps, have been excusable before the financial sector crisis of 2007. But not in the light of what the crisis has revealed. That crisis, as everybody knows, was brought on by a secular failure of private banks in the advanced economies, notably US and Europe. The crisis dealt a blow to the global economy from which it is yet to recover. India’s own hopes of sustained growth of eight per cent or more have been torpedoed as a result.

In the face of the failure of private banks during the crisis- and the appalling lapses in management and governance that it highlighted- for commentators in India to claim that privatisation is the answer to problems in our banking sector is quite a feat. It shows a certain disregard for the nature of the banking sector in general and the record of India’s own banking sector over the past two decades. So let us begin by getting basic facts right:

  1. There’s nothing private about banking: Critics of PSBs say that the government has no business to be in banking just as it has no business to be in airlines, steel or biscuits. It is because of government’s presence in banking through PSBs that the burden of ‘bailing out’ PSBs from time to time falls on the tax payer.

The comparison is flawed. Banking differs from biscuits or steel in one crucial respect: a biscuit or steel company can be allowed to fail but a reasonably sized private bank cannot. Why? Because there are “externalities” attached to bank failure- the costs to the economy exceed the private costs of failure.

Recapitalisation costs

When large banks in the US and the UK failed or were on the verge of failure in 2007 and thereafter, governments infused large amounts of public money into these banks. This was the familiar phenomenon of “privatisation of profits and socialisation of losses” that has caused so much public outrage in the western world (and partly explains the popularity of somebody like Bernie Sanders in the current US presidential race). Putting banks in private hands is no insurance against failure and hence against imposing burdens on the tax payer.

  1. The costs of recapitalisation in India are amongst the lowest in the world: The financial crisis of 2007 was not an aberration. It was merely the latest and most lethal of several financial crises that have rocked economies over the past several decades. An IMF study has documented 140 episodes of banking crises in 115 economies in the period 1970-2011. The median cost of recapitalising banks was 6.8% of GDP.

The recapitalisation cost, however, does not capture correctly the cost to the economy- it is only a measure of the losses that have occurred in the banking system. The true cost is the loss of economic output following a banking crisis. A study carried out by the Bank for International Settlements estimate the annual loss of output on account of a banking crisis to be of the order of 3% every year.

Now, let’s look at the record of the public sector-dominated Indian banking sector. In over two decades since banking sector reforms commenced, we have not had a single banking crisis (defined as the failure of multiple banks; hence the use of the expression ‘bailout’ to is not entirely accurate). The recapitalisation cost to the government (Rs 80,000 crore until 2014-15 plus the Rs 70,000 crore proposed over the next four years or a total of Rs 150,000 crore) amounts to 0.5 per cent of GDP in over two decades or an annual cost of 0.025 per cent. This is miniscule compared to the median cost of 6.8% cited above. Just to drive home the point, the cost of recapitalising one bank, Royal Bank of Scotland in the UK, in 2008 amounted to £45 bn or more than Rs 270,00 crore.

  1. India’s public sector banks showed an improvement in efficiency until 2011-12: Analysts are apt to compare the performance of PSBs with that of private banks and point to the relative underperformance of PSBs. Most of the analysis focuses on a snapshot of the figures for the past year or two.

Such a comparison is highly misleading. We need to look at trends in performance over a longer period. There is a wide body of research that points to a trend towards convergence in performance of PSBs and private sector banks in the post-reform period. Thanks to listing on the exchanges and market discipline, a greater focus on commercial objectives, and tighter regulation, PSBs lifted their performance until the first decade of 2000. Their performance started deteriorating post 2011-12. The slowdown in the Indian economy in recent years and, particularly, the problems in Indian infrastructure have led to a sharp divergence in performance between PSBs and private banks.

The primary reason for this is that PSBs have a greater exposure to infrastructure and related sectors than private sector banks (whose books are more heavily weighted towards retail assets). Now, you could say this was clever thinking on the part of private banks and poor thinking on the part of PSBs. But if PSBs had not financed private infrastructure during 2004-08, we would not have got the economic boom of that period in the first place! No finance, no boom.

And financing infrastructure was not entirely myopic on the part of PSBs. India’s infrastructure sector has been beset by woes that bankers could not have possibly anticipated in full- delays in land acquisition, problems with environmental clearances, lack of fuel supply linkages, etc. In retrospect, it is clear that the government should not have ceded its role in infrastructure development to the extent it did. It did so in order to contain its fiscal deficit. The impact on the fisc is being felt with a lag through the losses of PSBs.

Secondly, saddling banks with long-term funding is inherently flawed given that banks’ liabilities are of short-term maturity. Again, with the benefit of hindsight, it is clear that dismantling India’s development financial institutions which had focused on long-term finance was a mistake. PSBs are paying for these larger policy mistakes.

The private sector myth

What broad conclusions can we draw from the above? First, we must bury the myth that leaving banking to the private sector is what will make a difference. If anything, it is fair to suggest that private banking systems are congenitally prone to failure. Three factors- the ability to expand credit almost at will, high leverage and risk-taking incentives for managers- virtually predispose private banking systems to crises. Few believe that the reforms we have had worldwide since the crisis- such as higher capital requirements for banks, limiting the scope of banks, etc- will make a material difference.

Secondly, we cannot overlook the fact that one reason why the Indian banking experience has been refreshingly different is that we happen to have a PSB-dominated system. Overall, the system has shown an improvement in efficiency and stability. It does appear that, given what we have learnt from the financial crisis, we have a stark choice. We can have a wholly private banking system and pay the high cost that goes with recurring financial crises. Or we can have a public sector-dominated system which we recapitalise periodically at a lower cost- I would call this “pre-emptive recapitalisation” that helps stave off a banking crisis and that larger cost that entails.

We may debate what the appropriate share of the public sector should be- whether the present figure of 70% of assets is appropriate or whether it might fall to 60%. However, it would be unwise to dismantle public ownership of banking. We must focus on reforms within the framework of public ownership. Our experience shows that improvement within the framework is eminently feasible.

We need improvements in governance as well as management in PSBs. We certainly need more professional boards than we have had thus far. However, it would be wise not to overstate the important of boards- the failure of RBS inspite of having a star-studded board is a case in point. The crucial improvement required is a strengthening of management at all levels at PSBs starting with the CEO. This is an area in which the UPA government hugely let down the public sector: the appointment of CMDs in that ten-year period, as everybody knows, left much to be desired.

The NDA government’s proposal to have Bank Board Bureau, staffed with three officials of the government and three experts from outside, is a step in the right direction. However, these experts do not have to be from private sector banks or even from the broader private sector. Having people from the private sector creates the potential for conflicts of interest. There is no dearth of expertise elsewhere- retired public sector bankers of eminence, former deputy governors of the RBI, academia. More importantly, re-creating public sector banks in the likeness of private banks is emphatically not the answer – indeed, it could create the basis for a banking crisis where none has obtained for over two decades.

T T Ram Mohan is professor at IIM Ahmedabad

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  • Abbas Mookhtiar

    Privatisation of PSB’s is not the solution. In the recent past we have seen many private banks such as Global Trust Bank and other private banks run in the co-operative sector going bust and thereafter either being wound up or merged with some other bank. Take a look around and one can clearly see how many private sector companies (infact big groups) running up huge losses and becoming commercially insolvent/bankrupt and compare them with the number of public sector companies becoming commercially insolvent/bankrupt this will clearly establish that the private sector in India is equally a failure with many of the private sector owners fleeing the country with the wealth they are able to siphon off from their companies.