Paper 3-Privatisation of banks in India and debate around it "EMPOWER IAS"

 

Context: 

• It has been reported that the government continues to work on its stated position that most of the public sector banks will be eventually privatised.
• Banking will be one of the sectors where a bare minimum of the public sector will remain. This is the government’s stated policy.
• Earlier the government announced a Public Enterprise Policy, where it identified areas where public sector presence will be there. 
• Under the New Policy: Strategic: Atomic energy, space, defence, trans and telecom, power, petro, coal, other minerals, banking, insurance and financial services will be classified as strategic sectors.

 

 

Public or the private?

• The development view sees government presence in the banking sector as a means to overcome market failures in the early stages of economic development.
• The government-owned banks can improve welfare by allocating scarce capital to socially productive uses.
• The stellar success of Indian PSBs in implementing the PMJDY while missing the mark on creating high-quality credit highlights a critical divide between the asset and the liability side of a bank.
• Banks provide two functions at a fundamental level: Payments and deposit-taking on the liability side and credit creation on the asset side.
• The payment services function, a hallmark of financial inclusion, is similar to a utility business — banks can provide this service, a public good, at a low cost universally.
• The lending side, in contrast, is all about the optimal allocation of resources through better credit evaluation and monitoring of borrowers.
• Private banks are more likely to have the right set of incentives and expertise in doing so.
• It comes as no surprise that the PSBs in India are better at providing the public good functions, whereas private banks seem better suited for credit allocation.
• However, the political view argues that vested interests can influence the lending apparatus to achieve political goals.
• This results in distortion of credit allocation and reduce allocative efficiency in government-owned banking systems.

 

 

How public banks performed in India

• Public sector Banks (PSBs) dominate Indian banking, controlling over 60 per cent of banking assets.
• The private-credit to GDP ratio, a key measure of credit flow, stands at 50 per cent, much lower than international benchmarks — in China it is150 and in South Korea it is 150 per cent.
• India’s Gross NPA ratio was 8.2 per cent in March 2020, with striking differences across PSBs (10.3 per cent) and private banks (5.5 per cent).
• The end result is much lower PSB profitability compared to private banks.
• The rationale for privatisation stems from these considerations.

 

Reasons for Privatising Public Sector Banks

• Previous reform measures have not yielded results: Years of capital injections and governance reforms have not been able to improve the financial position of in public sector banks significantly. Many of them have higher levels of stressed assets than private banks, and also lag the latter on profitability, market capitalisation and dividend payment record.
• Aligned with Long Term Goal: Privatisation of two public sector banks will set the ball rolling for a long-term project that envisages only a handful of state-owned banks, with the rest either consolidated with strong banks or privatised.
• Reduces Government Burden: Privatisation will free up the government, the majority owner, from continuing to provide equity support to the banks year after year. The government front-loaded Rs 70,000 crore into government-run banks in September 2019, Rs 80,000 crore in in FY18, and Rs 1.06 lakh crore in FY19 through recapitalisation bonds.
• Rationalisation of Banks in Post-COVID Scenario: After the Covid-related regulatory relaxations are lifted, banks are expected to report higher NPAs and loan losses. This would mean the government would again need to inject equity into weak public sector banks. The government is trying to strengthen the strong banks and also minimise their numbers through privatisation.
• Changed Approach to Financial Sector Problems: Privatisation and proposal of setting up an asset reconstruction company entirely owned by banks, underline an approach of finding market-led solutions to challenges in the financial sector.
• Private Participation promotes innovation in market: Private banks’ market share in loans has risen to 36% in 2020 from 21.26% in 2015, while public sector banks’ share has fallen to 59.8% from 74.28%. They have expanded the market share through new innovative products, latest technology, and better services.

 

Case for privatising banks

• Non-performing assets: The major problem faced by banks is on account of non-performing assets, which is common for both the private and public sector banks.
• Capital Adequacy ratio: The government also has difficulty in providing additional capital to the government banks on account of fiscal constraint.
  • The banks are in need of additional capital to maintain Capital Adequacy Ratio for continuing their lending operations. 
  • Capital Adequacy Ratio (CAR) is the ratio of a bank’s capital to its risk.
  • It is decided by central banks and bank regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.
  • The Basel III norms stipulated a capital to risk-weighted assets of 8%.
  • In India, scheduled commercial banks are required to maintain a CAR of 9% while Indian public sector banks are emphasized to maintain a CAR of 12% as per RBI norms.
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What are the challenges associated with increasing Privatisation of Banks?

1. Private banks are not without faults

• In the last couple of years, some questions have arisen over the performance of private banks, especially on governance issues. 
• ICICI Bank MD and CEO Chanda Kochhar was sacked for allegedly extending dubious loans. 
• Yes Bank CEO Rana Kapoor was not given extension by the RBI and now faces investigations by various agencies. 
• Lakshmi Vilas Bank faced operational issues and was recently merged with DBS Bank of Singapore. 
• Former Axis Bank MD Shikha Sharma too was denied an extension.
• Moreover, when the RBI ordered an asset quality review of banks in 2015, many private sector banks, including Yes Bank, were found under-reporting NPAs. 

2. Dangers of private banks repeating the mistakes of 1960s

• There is widespread perception that the private sector then was not sufficiently aware of its larger social responsibilities and was more concerned with profit.
• This made private banks unwilling to diversify their loan portfolios as this would raise transaction costs and reduce profits.
• The expansion of branches was mostly in urban areas, and rural and semi-urban areas continued to go unserved

 

Way ahead:

• The optimal mix of the banking system across public and private boils down to what you need out of your banking system.
• When the wedge between social and private benefits is large, as with financial inclusion, there is a strong case for public banks.
•  At this stage, inefficiency in capital allocation seems to be a bigger issue for the Indian banking sector, whereas, in the US, the debate is centred around the public goods aspects of banking.