In an opinion piece just after the last general elections (‘What holds us back’, The Indian Express, May 23, 2014), I had argued that while the politics of policymaking might have become easier, economic reality hadn’t, and that the new government would need to identify and address the key constraints to India’s growth early on. One of those constraints was the alarming rise in corporate leverage amidst weakening growth and the consequent deterioration in banks’ loan quality. The government moved glacially, hoping that growth would take care of the problem and only recently realised that the high leverage itself was holding back growth. However, over this period, banks’ credit quality worsened to a point where it now needs, in the words of RBI Governor Raghuram Rajan, “deep surgery” and not “band-aids”.
Much of the public discussions have focused on two aspects of the debt problem. First, finding clever financial engineering solutions to fill the hole in the books of the banks (mainly public-sector banks or PSBs) as the government has committed woefully inadequate budgetary resources compared to any reasonable estimate of the required recapitalisation needs. But financial engineering doesn’t erase bad debt; it only repackages it. Eventually, there has to be a transfer of real resources to fill the hole created by the bad debt. If the history of debt crises is any guide, it is likely to be India’s households that will pay for it through more financial repression or higher future taxes.
The second has been to use this funding pressure as an opportunity to enforce changes in PSBs aimed at improving their investment choices, purportedly because this got them in the mess in the first place. Most of the proposed changes are based on the recommendations of the P.J. Nayak Committee, and they range from greater separation between owners and management to changes in compensation packages that encourage better pricing and assessment of risk. I particularly favour the call for protecting bank managements from legal and criminal charges just because an investment decision turns out to be wrong later. As this year’s Economic Survey rightly exhorts, India needs to learn to tolerate investor mistakes and allow exits.
While capitalising PSBs and improving their efficiency are obviously important, I will argue that neither addresses the elephant in the room. Whether financial engineering provides a lease of life to these banks to live through another debt cycle or management changes are made to hopefully dampen future cycles skirts the more fundamental question: Do we need PSBs?
When Indian banks were nationalised in 1969, the ability of private banks to mobilise resources, that is household savings, was weak and their competence in allocating resources to meet India’s investment needs questionable. Over the next three decades, PSBs played a critical role in better garnering household savings, funnelling them into the formal financial system, and fund the country’s development needs.
But over the last 25 years, successive governments have implemented extensive reforms to liberalise the system that, in turn, has substantially deepened India’s financial markets and allowed private banks and non-bank financial institutions to grow and become important players in the resource mobilisation process.
So do we still need PSBs to mobilise savings? Put differently, it is not a question of making the PSB branch in Churchgate function more efficiently, which is what the P.J. Nayak Committee recommendations intend to achieve; the question is whether there is even any need to keep the branch open.
I am not arguing that there is no role for PSBs. There is. In a country where both rural and urban poverty is rampant, goods and labour markets deeply distorted, and where vast swathes of the population remain outside the ambit of the formal financial sector, there are important social and development functions that only publicly owned banks can perform. But these are much more limited functions, that is, those that the private capital market cannot do. Not the universal banking behemoths that today’s PSBs have become.
So here’s a solution. Rather than tweak compensation packages or spend more taxpayer money to recapitalise, the government should sell all PSBs, as is, to existing and newly licensed private banks. (The investment subsidiaries, such as mutual funds, can be sold to non-bank financial companies.) The private sector is unlikely to have immediate capital to take over their public-sector counterparts simply because of the mammoth size of the latter, so some form of deferred payments needs to be designed. With the privatisation funds, the government can then capitalise a handful of retail policy banks (as opposed to the wholesale policy banks of today) that have an explicit, but limited, mandate to carry out specific social and development functions that private capital markets cannot. Employees of the disbanded PSBs who are not re-employed by the private banks or by the policy banks can be compensated (even generously) using part of the privatisation proceeds. There are many details to fill in: Should the sale be limited only to local banks or opened to foreign ones as well or should the retail branches be limited only to rural areas and second-tier cities, etc? Then there is the question of amending the various banking laws.
No doubt, the process will be arduous with significant political challenges. A 50-year-old system necessarily creates its own deeply entrenched vested interests, including parts of the Central and state governments that fear eventually losing a captive source of budget financing. But that doesn’t mean we should not raise the question especially since one ends up getting a far more efficient financial system to carry out market economy functions, and, at the same time, establish financial institutions whose social functions are explicit, with unambiguous accountability.
I am not holding my breath that any of this will happen. By the sounds of it, the government, the regulator, and the market are quite comfortable with some more band-aids. They just need to appear a bit more like deep surgery.
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