Money & Finance

The big bank theory

  • Blog Post Date 11 May, 2018
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Maitreesh Ghatak

London School of Economics

The Indian banking system is saddled with non-performing and stressed assets, which currently constitute about a quarter of all assets. In this post, Maitreesh Ghatak argues that while there are valid fears about inefficiency and corruption in the public sector and political interference in the operation of public sector banks, a knee-jerk response of privatisation may be misguided. There is a need to understand the deeper systemic issues.

The Indian banking system has been in the news for the wrong reasons lately. A certain diamond merchant, who shares the same surname as the Prime Minister, has quietly fled the country after being accused of defrauding the Punjab National Bank of Rs. 117 billion. Add this to the amount of Rs. 85 billion owed by another flamboyant businessman now in exile, and you get almost two-thirds of the total government health budget. Yet this is just the tip of the iceberg.

The Indian banking system is saddled with non-performing assets (NPAs), which is a polite term to describe loans that are never going to be repaid because they are to a large degree nothing but organised loot carried out by businessmen in connivance with bank officials. The Reserve Bank of India’s Financial Stability Report (December 2017) points out that NPAs stand at 10.2% of all assets, while assets that are described as ‘stressed’ and which are in effect NPAs stand at 12.8%. Together, this is nearly a quarter of all assets, even though that is believed to be an underestimate.

We now have the usual clamour for reforms that follows any major scam. Some are calling for privatisation of public sector banks (which constitute about 70% of the banking system), while others are advocating governance reforms that shield public sector banks from the nexus between businessmen, political parties, and bank officials that constitutes a textbook model of crony capitalism.

Put this way, privatisation seems like an obvious solution, but that would be misguided for two fundamental reasons.

First, the private sector in India is not a model of virtue. As was pointed out by State Bank of India Chairman Rajnish Kumar, it is private sector companies that are the main defaulters if we look at who are hauled up to the National Company Law Tribunal for insolvency proceedings. Large borrowers account for 56% of advances but 83%of NPAs. And, there have been enough scandals involving private banks and financial institutions, from running Ponzi schemes with the money of small savers to money laundering during demonetisation. Also, the ratio of NPAs to assets for scheduled commercial banks is 9.6%, not too far behind that of the public sector banks (12.5%).

Second, public sector banks serve rural areas, where more than two-thirds Indians live – much more than private sector banks. No surprises here – the private sector moves in only where profits are to be made, and so the public sector has to step in to fill the vacuum.

Moreover, poorer borrowers such as small farmers– like the ones who marched into Mumbai recently to protest their dire economic condition– depend largely on informal lenders. While state governments waive loans of Indian farmers that amount to billions, this applies to formal credit only and does not benefit poor farmers who rely on informal lenders. According to the All India Debt and Investment Survey (2012), nearly 48% of farmers took loans from moneylenders and landlords, often at exorbitant interest rates, which is often the back story to news on farmer suicides. 

While public sector banks appear highly scandal prone, there have been enough scams involving their private counterparts.

So, while there are valid fears about inefficiency and corruption in the public sector and political interference in the operation of public sector banks, a knee-jerk response of ‘let’s privatise’, like ‘off with her head’, will be misguided if we do not take into account the above considerations. We need to understand the deeper systemic issues.

The debate surrounding the crisis in the Indian banking sector has echoes of the old debate about central planning versus markets that economics college students in India until the early 90s had to study, and of the rhetoric about how our mixed economic system was supposed to have been the best of both worlds.

There may be something very Indian about liking things that are ‘mixed’ – just look at the menus in restaurants or popular homecooked items like khichdi. This may be an expression of our inherent ‘unity in diversity’ ethos or syncretic nature. But more generally, as with asset portfolios, ‘mixed’ sounds good since it seems more balanced and therefore less risky.

India’s mixed economy was guided by Five-Year Plans. The Government had control over the commanding heights of the economy through the Planning Commission and various ministries, and the private sector was allowed to operate but as an obedient subordinate to the public sector. As students, we thought, ‘Who could be possibly against planning?’ After all, in almost every aspect of life, planning is good (the opposite of it being chaos).

Those were days of innocence.

In subsequent decades, the centrally planned economies of the Soviet Union and Eastern Europe imploded like buildings in an earthquake; China continued its rapid journey to a more market-based economy that had started with privatising collective farms in the late 70s; and India embarked on a path of economic liberalisation in the early 90s, becoming a much more open and much less regulated economy and moving away from what was disparagingly called a model of ‘post-office socialism’, where the entire economy is run like a post office with its associated delays, inefficiencies and lack of variety, dynamism, and innovation.

Somewhere along the way, the words ‘mixed economy’ and ‘planning’ have become nearly obsolete.

In hindsight, we now realise that with ‘mixing’ there was no guarantee that you would get the best of both worlds – you could also get the worst of both! As with the famous story about someone very beautiful proposing to marry someone who was very intelligent to have a child who combines the best of both parents’ traits, what’s the guarantee that the child will inherit the looks of the former and the brains of the latter and not the other way around?

Central planning didn’t work out because if a single entity– the State –is given charge of planning for the whole economy, it would need to be omniscient, omnipresent, omnipotent, and in possession of perfect foresight for it to work. What is worse, even if the central planning authority did possess such a capacity, we would need to have the confidence that it will act in the best interests of society. But there is a basic fallacy here. The moment you have coercive powers to do what you want, you have no incentive to stay benevolent and use it for the greater good, as your own survival would depend on putting your own interest above that of rest of society.

No wonder, then, that centrally planned economies eventually imploded. They were unable to generate enough economic surplus for the population. Moreover, as central planning does not work without coercion, these countries had political systems that were (and in some cases, continue to be) effectively dictatorships.

If we think of the typical problems we associate with India’s public sector banks (or the public sector more broadly), they correspond to the typical problems of central planning. There are problems of information which results in bureaucratic sluggishness and inefficiency. There are problems of incentives –if you expect to be subsidised by the taxpayer for any losses that arise, you will have no incentive to be proactive in avoiding losses. And, there is the problem of political interference –if the government has direct control over those running the banks, cronyism is bound to arise.

If central planning does not work, and that is why the public sector has inherent limitations, do we then just need to embrace a pure market-based system? Isn’t that the spirit of liberalisation and reforms that Narendra Modi was elected to carry out?

The problem is that pure market systems do not exist anywhere and for good reason. Even in the supposedly most ‘free market’ country in the western world, the United States, total government spending at the federal, state, and local levels is approximately 36.1% of gross domestic product (GDP).

There are several reasons why a pure market system cannot work.

Without proper regulation and rule of law, there is nothing to stop markets from exploiting the poor and the uninformed, cheating workers and consumers, or damaging the environment. Left to market forces, essential public goods like health and education will not be provided at adequate levels except for the very rich who can (and often do) effectively create their own ‘gated’ economy run like a club, literally and metaphorically.

It is well-known that market economies by their very nature tend to generate inequality –and eventually, instability. There is no more potentially destabilising force in any economic system than the desperation of those who are pushed to the brink of survival, even when they are as peaceful as the distressed farmers in Maharashtra who marched to Mumbai. To prevent the discontent of large segments of the population from disrupting social and political order, governments need to provide a social safety net for the economically disadvantaged. Even if there is no moral concern for the condition of the less fortunate, sheer pragmatism would dictate such measures.

But beyond these general drawbacks, financial markets constitute a particularly vulnerable aspect of a market economy for a number of reasons.

First, financial returns depend on expectations of the future– popularly referred to as ‘market sentiments’ –that are inherently uncertain and subject to swings in the mood of investors. This makes financial markets naturally prone to volatility, often leading to speculative bubbles and crashes. 

Since banks are ‘too big to fail’, given the risk of contagion to the financial system, government presence can't be wished away.

Second, there is a fundamental way in which financial transactions are different from other transactions. When you buy an apple or get a haircut, money is exchanged against a good or a service. But financial transactions involve the exchange of something real (namely, money) against only a promise– such as to repay a loan or pay dividends– that by its very nature is fragile and unreliable.

Third, there is the mutual dependence of financial claims. For example, banks lend to each other through the interbank market and so the insolvency of one bank infects all other banks through this interdependence. Moreover, if depositors get panicky and start withdrawing money, it may lead to a domino effect of bank runs that could threaten the whole economy.

In other words, financial impulses run through the economy like blood circulates in the human body; any infection in one part quickly spreads all through the body. That is why it is standard practice for governments in India and abroad (as in the 2008 financial crisis) to use taxpayer money to bail out failing banks and other financial institutions. This happens even if they were guilty of taking on bad risks out of greed or of colluding with unscrupulous businessmen who effectively embezzled the money entrusted by savers. They are ‘too big to fail’, given the risk of contagion to the entire financial system.

So, while privatisation does reduce government interference on a day-to-day basis, the presence of the government cannot be wished away. After all, you cannot have collective ownership of losses and private ownership of profits.

The challenge is to come up with a system of public ownership of equity in private banks that gives the government some oversight of their management, as with a major shareholder and yet puts a firewall that prevents interference in day-to-day management by politicians and bureaucrats. Also needed is a governance and monitoring system that minimises the inherent incentive problems that arise if private banks know they will be bailed out in the event of big trouble.

As much as the old debate about central planning versus markets is obsolete, we need to go beyond the privatisation versus nationalisation debate. There will always have to be a mix of the market and the government, and a mix of private and public banks. The question is, what is the right balance and how is it to be achieved?

There is no magic formula that tells us what fraction of market or what fraction of government intervention is optimal. In fact, the search for such a formula is problematic in itself, for it traps us in a ‘central planner’ mindset again.

In an ever changing and complex world inhabited by millions of economic actors, we cannot plan for the desired outcomes as there will always be some uncertainty. But we can agree on desirable processes. That will ensure we stay on the right track, even though sometimes we may get lucky and sometimes unlucky. As an analogy, while we cannot plan for the exact meals we are going to have all through the year, as that might depend on availability, resources and our spontaneous desire at a given moment, we can agree on some general dietary rules and set a budget that will keep us happy and healthy on average.

The focus of banking sector reforms, more broadly of all economic activity, should be on creating transparent and uniform rules that apply to everyone and minimising the discretionary power of politicians and bureaucrats. This is where the recommendations of the P.J. Nayak headed Committee to Review Governance of Boards of Banks in India on reforming the governance of State owned banks are worthy of serious attention. The operative principle should be to move away from discretion and micro-management by the government beyond setting a clear policy goal about lending priorities for sectors not well served by commercial banks. That is the door through which most of the problems of corruption and inefficiency that beset the public sector banks arise. Yet, these are precisely what gives the government power and influence, and are thus unlikely to be voluntarily given up.

Even if we accept the premise that Modi is sincere in his desire to clean up the mess, his basic approach is that of a central planner, who relies on heavy-handed measures of command-and-control using the administration. This is not just in the case of banking, but evident in the manner of implementation of Aadhaar, the stalled land acquisition bill, the ill-conceived and badly executed demonetisation exercise, and even the healthcare reforms that are currently underway. This is ironic, as Modi promised to dismantle the rusty pillars of the Nehruvian State and foster a more bottom-up entrepreneurial environment, putting faith in people.

Central planning is dead. Long live the spirit of the Central Planner!

This article first appeared in Open Magazine:

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