In 1948, the Congress Party’s Economic Programme Committee recommended bank nationalisation as a step towards a “just social order”. This sentiment found policy expression in 1969, when the government, in spite of RBI’s opposition, nationalised 14 banks. In 1980, six more banks were nationalised, this time on the recommendation of RBI Governor Dr I G Patel. It is ironic that these public sector banks (PSB) are in trouble today because of loans to big corporates and frauds involving powerful persons. And that loans to priority sectors, such as agriculture, MSMEs, etc account for about 38 percent of loans of PSBs, but only about a quarter of their bad loans.
Years later, in his memoirs, Dr Patel stated that although nationalisation was a “great success initially,” things went wrong soon after. There was “overstaffing” and “indiscipline and incompetence without any fear of being accountable”. This, in his view, led to deterioration in merit and customer service, while the emphasis was on “closeness to political power”.
Mixing politics with finance
Banking is generally disaster-prone, but PSBs face certain unique problems. They have commercial as well as public policy objectives. This is more so in India, because, as development financial institutions faded away, PSBs took over their functions, while continuing commercial banking. For instance, responding to a policy priority, PSBs rapidly scaled up lending to infrastructure, giving loans to projects they had little expertise to evaluate, and taking risks they could not manage.
There is some evidence that PSBs also help with electoral objectives. Research shows that PSB lending to agriculture increases disproportionately in election years, with large increases in districts with close election. Bank presence increases dramatically in the Finance Minister’s constituency.
The confusion about incentives percolates through the organisation, makes it difficult to enforce clear decision-making criteria and to hold persons and groups accountable. Perhaps, through organisational culture, this may also affect purely commercial lending decisions.
When a loan goes bad, PSB employees find it difficult to take tough decisions to minimise losses. For instance, a decision to sell a bad loan at a loss is difficult for PSB employees. Being public servants, they face threat of corruption allegations. The incentive is towards holding the loan or even continuing lending to the borrower in the hope that the loan will turn around.
PSBs also face constraints in rewarding good performance and punishing bad conduct. Government ownership complicates human resource decisions. With about 8 lakh well-organised, mostly middle-class employees, unions of PSB employees are powerful. These unions seek low accountability for employees and continuous government-financed recapitalisation. In January, the unions even opposed the RBI’s prompt corrective action against troubled banks.
These features of PSBs do not explain why the fraud at PNB could not have been avoided, but they shed light on the context for the larger crisis of bad loans and weak systems.
Regulation of PSBs
Bad loans in PSBs are 16.2 percent of their loans, while only 4.7 percent of loans by private banks have gone bad. RBI’s supervision seems less effective with PSBs. In some ways, government ownership blunts effectiveness of supervisory instruments. Monetary penalties ultimately affect the taxpayers (and minority shareholders, who have little say). Powers such as superseding of board are difficult to use when the board is Sarkari. However, we shouldn’t over-emphasise these constraints.
In PSBs, RBI nominees are on the Board as well as on the Management Committee, which approves large loans and write-offs. Within its considerable statutory powers, RBI could have insisted upon better lending practices even where government’s priorities were being pursued. Also, many bad loans are in sectors where there was no policy push.
Once stressed loans started piling up, for years the RBI allowed restructuring schemes that enabled banks to delay recognition of bad loans. This approach did not work, and the restructuring schemes have now been withdrawn. Also, the PNB fraud shows fundamental process failure in the bank, the auditors, and the regulator.
Is there an implicit grand bargain that RBI will take PSB regulation lightly, with an understanding that PSBs will do the government’s bidding and government will bail them out? If this is so, frauds are unintended by-products of this arrangement.
Crises in banking are costly to the economy, especially in bank-dominated economies. In India, about 43 percent of borrowing by non-financial firms is from banks. The present crisis began in real economy firms, was transmitted to bank balance sheets, and now threatens to become a drag on the economy by squeezing credit supply. Between 2014-15 and 2017-18, the government has infused about Rs 1.5 lakh crore into recapitalisation of PSBs, and has budgeted Rs 65,000 crore in 2018-19. The crisis needs to be tackled, but it is also necessary to have a strategy for PSBs, even if the strategy is implemented over a few years.
Although, in principle, it is possible that PSB lending may lead to social benefits, this usually does not happen to an extent that justifies government ownership. The costs of government intervention are usually more than the benefits. India is not unique in this regard. In most countries, the experience with PSBs has been bad. It would be a mistake to assume that the structural problems of incentives and accountability can be overcome by “reforming” the PSBs.
The main strand of the strategy should be to privatise most of the PSBs over time. International experience on privatisation of PSBs has been mostly good. In India, research on privatisation of non-financial firms found substantial gains in profitability and productivity, without layoffs of employees or reduction in employee compensation.
Given that PSBs are “useful” for government, privatisation will require a strong commitment to ideas over interests. Privatisation is also politically difficult. In 2000, the government tried amending a law to allow reducing government stake to 33 percent. The unions called a strike, and the government backed down.
Some would argue that privatisation may hurt depositors, as they consider PSBs as “safe”. Actually, there is no explicit guarantee that government will come to the rescue of PSBs, but in practice, it has done so. This has created an expectation of safety. During the 2008 crisis, there was a “flight to safety” from private banks to PSBs. It would be better to improve protection for depositors in all banks and to encourage people to invest in government securities.
Recently, retail investors have been allowed to purchase government securities through regular depository accounts. For protection of depositors, deposit insurance limit should be raised, and a system for early resolution of failing banks should be established. Such a system is being considered by the Parliament – the Financial Resolution and Deposit Insurance Bill.
Beyond privatisation, the options are not good, but may be better than the status quo. One option is to mandate that, from now onwards, every additional rupee that the weakest PSBs collect will be invested in government bonds or highly rated corporate bonds. Over time, this would convert such PSBs into safe “narrow banks”, and also help foster the bond market. Another option is to gradually focus lending of some PSBs towards sectors where government-backed lending is justified (eg. agriculture, early stage infrastructure development), while defining accountability measures, and making the government’s promise of recapitalisation of such PSBs explicit.
The experience of bank nationalisation shows how sometimes solutions can be worse than the problems. So any strategy for PSBs must be formulated after careful consideration of the pros and cons.