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 privatization 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:
- 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
“privatization of profits and socialization 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.
- 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 recapitalization 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 minuscule compared to the median cost of 6.8% cited above. Just
to drive home the point, the cost of recapitalizing one bank, Royal Bank
of Scotland in the UK, in 2008 amounted to £45 bn or more than Rs
270,00 crore.
- 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 recapitalize periodically at a lower
cost- I would call this “pre-emptive recapitalization” 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.
Source : T T Ram Mohan, professor at IIM Ahmedabad
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