Time to revisit the idea of public sector banks

Why was in news?images

Reserve Bank of India (RBI) deputy governor Viral Acharya had said that reprivatization of some government banks may be an idea whose time has come. The idea is still very controversial, which is why he framed it as a question for discussion, arguing that it would reduce the amount of capital the government would need to inject into the banks, thus preserving hard-earned fiscal discipline.

In support of nationalization of banks:

In his July 2009 budget speech, Pranab Mukherjee had claimed that government ownership of the financial system was the main reason why the Indian economy had managed to stay on an even keel despite the turbulence around the world after the collapse of investment bank Lehman Brothers a few months earlier.

Why need to revisit?

The dominance of public sector banks was supposed to have lent the Indian financial sector unique stability in an unstable world. All this is now worth remembering at a time when the state of the Indian banking sector—still predominantly owned by the government—is the single biggest risk to economic stability.

Even as the Indian central bank and the finance ministry struggle to deal with the stock of bad debts that has clogged the banking system, it is worth kicking off a debate about what needs to be done to avoid a repeat of the current mess.

Suggestions:

  1. Government ownership of the Indian banking sector needs to be drastically reduced.

Bank privatization is a worthwhile project for the government to follow. The starting point should be reviving the proposal tabled in Parliament by the Atal Bihari Vajpayee government to bring down government holding in public sector banks to 33%.

  1. Allow new private sector banks to bloom

Privatization of public sector banks will necessarily be a slow process. It requires legislative change. Investor interest in many of the weaker banks will most likely be absent. And most public sector banks trade at discounts to book value, so the government will in all probability come under attack for selling at low prices. The government should thus shift its attention away from the current enthusiasm for public sector bank consolidation to promoting bank competition through the creation of new private banks. Such privatization by stealth needs to be promoted even as the bigger battle for public sector bank privatization is fought.

  1. India needs a more diverse financial system so that banks are not burdened with tasks they are not suited for.

The current mountain of bad debts can at least partly be explained by the pressure from New Delhi during the tenure of the previous government to fund large infrastructure projects as well as generally push lending at a rate that was far faster than the underlying growth in nominal gross domestic product. The result was a credit bubble that later popped.

The government needs to back the RBI in its quest to build a diverse financial system through the growth of finance companies, specialized infrastructure lenders and the corporate bond market. The recent shift in corporate lending patterns—especially the growing importance of non-bank sources of funds—needs to be further encouraged.

Bank nationalization did have its historical role, especially the financial deepening in the 1970s as a result of the expansion of the branch network. The result was higher savings that created the conditions for the acceleration of economic growth after 1980. But the damage done was also immense. Lending directed by the state rather than business calculations has meant that Indian banks have slipped into crisis mode at the end of every business cycle.

What is consolidation of Indian banking?

Talks on consolidation in Indian banking have been going on for almost two decades. A seminal report on banking reforms, authored by a panel headed by former Reserve Bank of India (RBI) governor M. Narasimham in 1998, recommended merger of banks to make them strong. In fact, it was in favour of a three-tier banking structure with three large banks with international presence at the top, eight to 10 national banks at tier two, and a large number of regional and local banks at the bottom.

Conclusion:

Bank nationalization did have its historical role, especially the financial deepening in the 1970s as a result of the expansion of the branch network. The result was higher savings that created the conditions for the acceleration of economic growth after 1980. But the damage done was also immense. Lending directed by the state rather than business calculations has meant that Indian banks have slipped into crisis mode at the end of every business cycle.

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