It’s been over two-and-a-half years since Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) in the US supporting housing finance, were placed in government conservatorships, effectively making them wards of the US treasury. These two GSEs are emblematic of the excesses of residential mortgage lending in the decade of the 2000s, benefiting from the implicit guarantee of the government in raising debt and deploying it to take massive bets on the upside by underwriting poor-quality residential mortgages. The US treasury has already made over $150 billion in capital contributions to keep them afloat, and much more is likely to come. And yet, the share of GSEs in mortgage underwriting business has grown from 50% at peak of the housing boom in 2007 to more than 90% of the new mortgages last year.
To Indians, it would seem surprising that government involvement—or interference—in the economy of this sort and magnitude would feature in the US, the bastion of capitalism, as this has traditionally been the prerogative of governments in less developed economies. The bigger lesson though is that where there are GSEs, government-sponsored crises follow.
Unfortunately, there are distinct parallels between GSEs in the US and India’s state-owned banks which own more than 70% of the banking assets. First, affordable home ownership goals set by the US government, which encouraged GSEs to own mortgages made to low-credit quality households, relate to “priority sector lending norms” in Indian banking, focused on agriculture and small scale industries, but which also include housing. Second, the forbearance exhibited towards GSEs—in good times through subsidized funding and generous capital requirements and in bad times through government conservatorship—mirrors closely the reluctance of the Indian government to shut down any state-owned bank or rural cooperatives that substantially aid the priority sector lending goals and have been shown in academic research to induce an “election” cycle in agricultural lending. And, as over time, GSEs have crowded out the private financial sector in the US residential housing market, so have the state-owned banks in India crowded out the private sector in rural banking, and in fact, increasingly in other aspects of financial services, too.
When the crisis hit India somewhat unexpectedly in 2008, savers in the Indian economy, fearing a banking crisis and runs on the private sector banks, started moving their deposits to public sector banks. And unsurprisingly, when the Indian government announced a number of wide-ranging stimulus plans to jumpstart the ailing banking system, several weak public sector banks received a significant share of stimulus to restore their capital levels. The credit grew for public sector banks by 20.4% in 2009 (compared with 22.5% in 2008), whereas for private sector banks, it grew by only 10.9% (compared with 19.9% in 2008). In the retail segment, public sector banks came out with inexpensive housing, auto, and education loans, emerging as the lead financers, for example, in the Tata Nano auto purchases.
This episode appears to have stacked the odds against the private financial sector considerably since. They are in effect getting somewhat crowded out. The government, however, has yet to recognize—or acknowledge—that the growth of state-owned banking sector since 2008 has been the effect of state guarantees, not state ownership. Banks all over the world were stabilized once governments back-stopped them. This emergency back-stop need not, however, be coincident with the misfortunes associated with state ownership in good times. One, state ownership creates severe moral hazard of directing bank branching and lending for politically expedient goals and of bailouts when such lending goes bad. Second, this also restricts the ability of state-owned banks from raising arm’s length capital against state’s stake, strangling their growth and keeping these banks—and certainly their private capital base— smaller than it need be.
There is an emerging political consensus against the pre-crisis notion that the state-owned banks be fully privatized in due course. The story of how government-sponsored enterprises morph into hedge funds of the likes of Fannie and Freddie that are guaranteed to fail should strike a note of caution to this stance of Indian policymakers. Indeed, an Indian GSE has been before where Fannie and Freddie are now. For more than two decades after its creation in 1963, the Unit Trust of India (UTI) remained the sole vehicle for investment in the capital market. UTI rode the stock-market rise of 1990’s and its flagship scheme, US 64, continued promising returns as high as 18%, till the “Ketan Parekh scam” burst the market. A full-fledged run on the stock markets would have likely ensued had the government not come out with a rescue package. UTI Act was repealed, UTI was broken up, and UTI Mutual Fund still runs, but now like any other mutual fund, controlling less than 10% share of the market and operating at a distance from the government. As UTI’s “unwinding” shows, things work out well in the private sector when government lets go in a graceful manner.
India was a darling of the Western media in 2010. Its demographic appeal and its democratic politics make it a country whose growth much of the world would like to see flourish in the decades to come. Yet, I worry that India’s Achilles heel may well be the same as that of the US: an overarching clutch of the government that becomes a crutch in bad times, rather than the gentle invisible arm and creative destruction of private financial markets. There’s no better time for the government than now to privatize state-owned firms not just in banking but also in other sectors such as oil and gas, power, and aviation.
Viral V Acharya is professor of finance at New York University Stern School of Business and co-author of Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance (released by HarperCollins with a chapter on Indian state-owned enterprises).
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