Why we don’t need PSBs: Bank privatisation must be on the reform agenda of the next government

by Arvind Panagariya

April 4, 2018

The Times of India

The banking sector, a major engine of growth, has been greatly underperforming in India. This is an inherited problem for the present government. Experts in finance had known for some years that the vast majority of the “restructured” loans would eventually turn into non-performing assets (NPAs).  But the finance ministry and Reserve Bank of India (RBI) were slow to move towards a solution.

Chad Crowe

Luckily, both of them have moved to take the NPA bull by the horns during the last year.  Armed with the Banking Regulation (Amendment) Act, 2017 and subsequent authorisation by the government, RBI has issued definitive directions to banks for time-bound resolution of stressed assets including through the Insolvency and Bankruptcy Code (IBC), 2016.  An impressive 40% of NPAs are now under the IBC process.

Three other important developments towards strengthening the banking system have taken place.  First, the finance ministry has moved decisively to recapitalise the banks.  This is already yielding happy results in terms of credit growth.

Second, through its 12 February 2018 directive, RBI has fully aligned the stressed asset resolution process to IBC, as in other countries with transparent bankruptcy laws such as the United States.  The resulting steady state process is transparent, time bound and fair to both borrowers and lenders.  Through the directive, RBI has also discontinued the pre-IBC alphabet soup of special resolution schemes such as CDR, SDR and S4A, which lenders and borrowers had used to delay rather than resolve stressed assets.

Finally, beginning a year ago, RBI has established a separate Enforcement Department.  This has filled an important gap in the deterrence armoury of RBI, bringing focussed and time bound punitive action once a regulatory violation is identified.

These reforms represent major steps forward towards creating a healthy banking system. But they are not enough.  In the longer run, full modernisation of the banking sector requires further structural reforms.  One such reform that must be high up on the agenda of the next government is privatisation of all public sector banks (PSBs) other than the State Bank of India.

I had concluded, in my 2008 book ‘India: The Emerging Giant’, that “any reform [of the banking sector] within the existing ownership structure would fall far short of what can be achieved by privatisation.”  Events of the past half dozen years have strengthened this conclusion. The case rests on three arguments.

First, scholarly research overwhelmingly shows that private banks exhibit significantly higher productivity and growth than PSBs.  Though not an end in itself, faster growth of banking is desirable for two reasons. One, it speeds up the growth of the economy thereby bringing overall prosperity faster.  And two, it translates into faster growth in credit and hence faster expansion of priority sector lending, an important social goal.

The second argument in favor of privatisation concerns governance.  Over time, committee after committee has pointed to myriad governance problems afflicting PSBs. The latest among them is the 2014 PJ Nayak Committee, which notes that the boards of most PSBs are increasingly compromised and lack the requisite sense of purpose.  It recommends radical reforms to empower the boards and make them responsible.  But these reforms are not on the policy agenda of anybody.

Advocates of government control keep repeating the worn out assurance that all we need to do is to allow governance reform a little more time.  But with solutions known for decades and no substantive action taken, only the most gullible can fall for such assurances.

Finally, the common argument that public ownership is required to pursue social goals is also greatly overstated. Most of these goals can also be pursued through RBI regulation and directives to private sector banks. The latter have satisfactorily delivered on the major social objective of priority sector lending for decades, sometimes even exceeding their targets.

As regards the other major social goal, rural banking, with digital revolution a reality, physical bank branches in rural areas have become even less cost effective than in the past.  Armed with payments bank license, it is institutions such as India Posts that now represent the wave of the future.

Even if certain social goals are better achieved through public ownership, they do not require the ownership of two dozen banks. For all practical purposes, one large PSB such as the State Bank of India should suffice.  Social benefits of PSBs must be weighed against the hefty social cost they repeatedly impose on the taxpayer.

Contrary to popular belief, Prime Minister Indira Gandhi had resorted to the July 1969 nationalisation not as an instrument necessary to achieve social goals but as a weapon to sack her political rival, then finance minister Morarji Desai. Rural bank branch expansion policy had already seen a beginning in 1962. Priority sector lending had also been launched via the RBI credit policy of 1968-69.

Abandoning his conviction, Desai had gone on to embrace the policy of social control to safeguard his position as finance minister.  But by nationalising the banks, Gandhi was able to convince people that Desai, who opposed the move, lacked the necessary socialist credentials to remain in his position.

DISCLAIMER : Views expressed above are the author's own.