It’s time to privatize banks

Government banks have become the weak underbelly of the economic system and need to undergo privatization as soon as possible


RBI deputy governor Viral Acharya has said that reprivatization of some government banks may be an idea whose time has come. Photo: Hemant Mishra/Mint
RBI deputy governor Viral Acharya has said that reprivatization of some government banks may be an idea whose time has come. Photo: Hemant Mishra/Mint

Reserve Bank of India (RBI) deputy governor Viral Acharya has said that reprivatization of some government banks may be an idea whose time has come. The idea is still very controversial, which is why he framed it as a question for discussion, arguing that it would reduce the amount of capital the government would need to inject into the banks, thus preserving hard-earned fiscal discipline.

Just why the idea of reversing a measure taken during India’s supposedly socialist heyday is still so controversial is unclear. After all, government ownership of banks is perhaps the most prominent example of the “commanding heights” of the economy being under state control. Surely the time has come to dismantle this relic of a command and control economy?

This isn’t the first time that Acharya has batted for privatization of India’s state-owned banks. He has done so much more plainly and forthrightly before he became a regulator. In an article on Is state ownership in the Indian banking sector desirable? written for the National Council of Applied Economic Research’s India Policy Forum 2011-12, Acharya pointed out, “One, state ownership creates severe moral hazard of directing bank lending for politically expedient goals and of bailouts when such lending goes bad. Second, state ownership 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.” No mincing of words there—his conclusion was that state-owned banks, which were at the time in the pink of health, should be privatized without delay.

Also Read: Will RBI walk the talk on bank consolidation?

Since then, as everybody knows, state-owned banks have racked up huge losses, which have come out in the open thanks to Raghuram Rajan’s insistence on clearing the Augean stables. It is also well known that state-owned banks perform poorly on a host of parameters compared to private sector banks. Perhaps the simplest way to compare the two sets of banks is via stock market valuations.

What the market thinks of public sector banks is seen in their price to book value multiples, which is around 1.2 for State Bank of India, the highest among public sector banks, compared to HDFC Bank Ltd’s 3.7.

The argument for privatization rests on whether the inefficiencies of the state-owned banks are offset by their larger social and developmental role. I recall, many years ago, the chairman of a nationalized bank holding forth about how the public sector banks (PSB) were responsible for the creation of a middle class in this country, thanks to priority sector lending.

As usual, the academic literature on the subject is inconclusive, with some arguing that government ownership of banks hampers development because of the political capture of the institutions and others claiming the contrary. A 2007 paper on the impact of government ownership on the Indian banking system by Shawn Cole of the Harvard Business School concluded that “Government ownership initially increased the quantity, and substantially lowered the quality of financial intermediation. An enormous increase in credit to agriculture had no measurable effects on agricultural investment.”

Interestingly, Acharya’s paper mentioned above was commented on by none other than Urjit Patel, who was at that time at the Brookings Institution. Said Patel, “On the policy side, the paper argues for privatization of Indian PSBs and other government-owned intermediaries. It is apposite to ask how closing the safe option for Indian savers will be welfare enhancing. Can it impact household financial savings and India’s overall savings ratio?”

Also Read: What the IMF global financial stability report says about India

He also pointed out, very appropriately, that the financial crisis had shown that banks that are too big to fail are bailed out by governments, in spite of them being in the private sector and private debts are then socialized. Arguing for privatization has become much more difficult since the financial crisis exposed the recklessness and chicanery of some of the most respected private sector banks in the West.

Reality, as always, is more nuanced than ideological grandstanding. There is little doubt that state-owned banks did indeed vastly expand rural lending and deposit-taking. Their purpose was not merely social amelioration. They have also lent for building infrastructure and to the corporate sector. In short, they have had an important role to play in economic development. But this role has come at a huge cost, to the extent that the weaknesses of some of these banks now pose a systemic risk. As the International Monetary Fund’s latest Global Financial Stability Report underlined, in more than a third of the Indian banking system, provisioning needs for bad debts would amount to three years of net income. Among emerging economies, asset quality in India is the worst, after Russia.

The objective of financial inclusion these days can be fulfilled by other means, thanks to technology having substantially lowered the cost of expansion in rural areas. Small banks, payments banks, microfinance institutions and many private banks are eager to tap the rural market today. Also, as the Cole paper pointed out, “it was not necessary to open government-owned bank branches in rural areas. Had the government imposed the same regulations (requiring expansion into rural areas, and setting lending targets), without nationalizing banks, rural areas may well have achieved the same, or better, outcomes.”

Will the government listen to Acharya? It hasn’t, after all, done anything much with the P.J. Nayak committee report. It also doesn’t seem to be a votary of privatization, preferring instead the state capitalist East Asian model. Perhaps it feels a command and control system has its uses. But the question is, even if the government were to listen to Acharya, who would buy these toxic banks? They will have to be cleaned up and made saleable before they can be disposed of.

Also Read: RBI’s Viral Acharya calls for reprivatization of nationalized banks

In fact, the role played by the state-owned banks was far from any attempt at ushering in “socialism” in India. On the contrary, they have greatly assisted in the development of a capitalist India, mobilizing savings, creating markets where none existed, transforming peasant cultivators into capitalist farmers, providing the huge funds needed for infrastructure and for private industry. Indeed, big capitalists have been the biggest beneficiaries of lending by state-owned banks. But just as the private sector in India needed the support of the Indian state in its initial days and can now dispense with that crutch, similarly there is now no longer a crying need for government banks. Putting it differently, from being a catalyst for the accumulation of capital in India, large sections of the state-owned banking system have now become the weak underbelly of the economic system, a fetter holding back the development of capitalism in India. They need to be privatized as soon as possible.

Manas Chakravarty looks at trends and issues in the financial markets.

To read Manas Chakravarty’s earlier columns, click here..

More From Livemint