Money & Finance

Public sector banks: The more things change, the more they stay the same

  • Blog Post Date 21 July, 2016
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Banks Board Bureau has been set up to help the government appoint heads of public sector banks (PSBs) and to advise on important issues in banking. In this article, Gurbachan Singh asks basic questions – what is the rationale for PSBs? Was there a rationale for the nationalisation of banks even in 1969? In his view, privatisation is needed but as a second-best solution, meaningful autonomy can be useful.

Twenty five years ago on 14 August 1991, the Narasimham Committee was constituted to suggest reforms in the banking sector in India. Many changes were made but these have by far and large failed to improve matters substantially. Given the alarming situation of 15% of all State bank loans going bad by 2014 (Sharma 2016), the issue of banking reforms needs to be revisited.

Recently, the Government of India (GoI) constituted the Banks Board Bureau (BBB) to improve the recruitment of the very senior personnel in public sector banks (PSBs) and to advise GoI on important matters concerning PSBs. While this is an important step, it is unlikely to change the nature and functioning of PSBs very much. There is need for more reforms. But before we come to these, let us go back to 1969 when 14 big banks were nationalised.

Alternative to nationalisation in 1969

It is true that prior to 1969 the banking industry had failed to take care of the needs of the economy in general and the banking needs of the poor and the middle class in particular. But it did not follow from this premise that nationalisation was the answer to the problems in banking. The reason is simple. By this argument, most of the Indian industry should have been nationalised at that time. After all, there was hardly any industry which served the common man well in those days. But except banking (and one or two other industries), there was no economy-wide nationalisation of industries, and rightly so.

In 1969, there was an alternative to the policy of nationalisation of major banks. To appreciate the alternative policy, note that before 1969, new banking licenses were hardly ever issued. This policy protected the existing banks from new competition, new products, new technologies, and more generally new ways of thinking that were yet to be discovered (Hayek 2002, 1968). The prevailing policy of restricted entry of new banks also contributed to the lack of significant expansion of banking in smaller towns (and the rural areas) before 1969. Competition from existing banks was useful but it had a limited role; there is always a need for entry or a credible threat of entry of new firms. Consider an analogy. There was sufficient competition from existing retailers even until about two years ago but it is the threat of the new e-commerce which is forcing the old-style retailers to change their ways and to reduce profit margins; this kind of potential competition was missing in banking before 1969.

Before the late 1960s, there was hardly any significant policy of, what we may call, social regulation of banks (except when the policy of ‘social control’1 of banks was announced by the GoI in 1968 but it was discontinued soon after to make way for nationalisation before it had even been proved that social regulation did not and could not work). In the absence of social regulation, private banks cared for profits alone and this was not always in the social interest. So what was required was social regulation. This could have been implemented as follows: Just as all the banks (whether private or public) are required to observe prudential regulation2, all banks could have been required to observe social regulation.

It is true that social regulation may have been inadequate. If (and it is a big if) that is so, the policy could have been supplemented by some explicit subsidy for banking for the weaker sections and for the priority sectors of the economy. That may have cost much less than what it is costing now in the form of huge losses of PSBs.

Way forward

The lessons from history (and economic theory) are that at this stage there is a need to privatise the PSBs, introduce social regulation, and liberalise by removing the barriers to entry and providing on-tap licenses without delay. If there is discomfort with complete privatisation in one go, it may be done in a phased manner. PSBs control about 32% of all banking assets in the 20 largest emerging market economies (EMEs). The figure is 75% in India (Sharma 2016). The GoI may want to privatise partially and bring the figure in India down to the level where it is in other big EMEs. The PSBs that are not privatised may be given meaningful autonomy; this needs to go well beyond constituting the BBB. Professor Mrinal Datta Chaudhury and Shri M.R. Shroff had written in a note (of dissent) in the Narasimham Committee Report in 1991 that “…the Government should not appoint its officials on the boards of the public sector banks…” (they explained their reasons).

Since the financial crisis in and around the year 2007 in the US, it is sometimes argued in India that PSBs are needed for macro-financial stability (Sonia Gandhi, 21 November 2008, Times of India). This argument is not valid. It is true that we should not imitate the US in banking. However, PSBs or at least non-autonomous PSBs are not the answer either. Instead, what is needed for macro-financial stability is an appropriate and effective legal and regulatory framework for banks that pays special attention to avoiding banking crisis and does so without imposing financial repression (Singh 2012a, 2012b). PSBs are neither necessary nor sufficient for macro-financial stability. Canada has had private and stable banking (Calomiris and Haber 2014). On the other hand, Indonesia had PSBs and faced a serious banking crisis (Hawkins and Mihaljek 2001).

By privatisation of PSBs, are we giving up on the welfare State? No, not if there is an increase in the tax-GDP (Gross Domestic Product) ratio in the economy. At present, it is about 17.5% (centre and states combined) in India; in a country like Denmark it is as high as 49%! An increase in the tax-GDP ratio can help to take care of social objectives; PSBs are not needed for this purpose.

On 6 January 2016, the GoI closed down HMT Watches Ltd. This used to be an important watch making company in India. It was not privatised; today it is nowhere. The GOI could have got good cash for privatising HMT Watches when it had value. The GoI could have used the money for the poor but it did not privatise. It is hoped that the PSBs do not go down the same way.

Summing up, the GoI has constituted the BBB. This is hardly anything very different from more of the same type of reforms that were spelt out 25 years ago. In my view, the GoI needs to take Indian banking beyond BBB; it is time to shift to ‘A PLUS’ - Autonomy, Privatisation, Liberalisation, Un-American banking, and Social regulation.

Notes:

  1. The priorities of private banks can be quite different from what the policymakers would like these to be. In order to get the private banks to take care of social objectives, the GoI announced the policy of ‘social control’ of banks. 
  2. An example is capital adequacy norms that banks are required to meet whether they are in the private or public sector.   

Further Reading

  • Calomiris, C and S Haber (2014), Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, Princeton University Press. Chapter 1 available here.
  • Hawkins, J and D Mihaljek (2001), ‘The banking industry in the emerging market economies: competition, consolidation and systemic stability - an overview’, Bank for International Settlements, BIS Papers, No. 4.
  • Hayek, Friedrich A (2002), “Competition as a discovery procedure”, The Quarterly Journal of Austrian Economics, 5(3), 9–23. Available here.
  • Narasimham, M (1991), ‘Report of the Committee on the Financial System’, Nabhi Publications, 1992.
  • Sharma, R (2016), The Rise and Fall of Nations – Ten Rules of Change in the Post-Crisis World, Allen Lane.
  • Singh, G (2012a), Banking Crises, Liquidity, and Credit Lines – A Macroeconomic Perspective, Routledge, Abingdon. 
  • Singh, G (2012b), “A review of Mohan, Rakesh, 2011, `Growth with financial stability – Central banking in an emerging economy’”, Margin - The Journal of Applied Economic Research, 6(3), 407-414. Available here.
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