State-run enterprises are not known to be efficient in allocating capital and creating value. What better example of this than the current lot of public sector banks that control more than 60% of the lending to the real sector. These lenders are buried under an unmanageable pile of bad assets, have huge holes in their capital base and have burned shareholder value over the last three years.

Perhaps the way this reflects on the state’s management of enterprises has prompted the International Monetary Fund (IMF) to push for greater participation of private capital in public sector lenders. In other words, the IMF wants the government to slowly withdraw its grip on banking. How can this be done? The Financial Sector Stability Assessment by IMF for India recommends reduction in government stake in public sector lenders to 52%, merging some lenders and privatizing others.

The stability report by IMF noted that “the state footprint needs to be rebalanced away from large ownership and directed lending toward better leveraging of public capital. A mix of greater participation of the private sector in capitalizing the PSBs and full privatizations would boost the banking sector’s capacity to support credit and reduce moral hazard and fiscal contingencies."

IMF’s recommendation comes on the back of its stress test on Indian banks wherein it found that in the baseline case, three banks will fail to meet regulatory capital adequacy requirement in the current fiscal year and in fiscal 2019. Public sector banks are the weakest, with the biggest pile of bad loans and sharpest erosion in capital.

To its credit, the government has laid out a plan through which it intends to reduce its stake in lenders over time. It has also announced a bank recapitalisation plan wherein the burden would be on banks to raise money rather than the exchequer alone. The government has clarified that capital infusion would not be free for all but based on merit and performance. This is a tacit indication of consolidation of weaker public sector banks. But IMF is not so gung-ho about such consolidation. It says, “Provision of public capital should be contingent upon meaningful restructuring of PSBs, and exit of weak banks (via sale of viable assets and liabilities to stronger public and private banks) should be considered, as consolidating weak PSBs into stronger ones risks undermining the viability of the acquirer." Where the government is dragging its feet is governance and regulation. Here too, IMF is urging the government to give greater powers to the Reserve Bank of India (RBI) and Bank Boards Bureau. RBI should be empowered to remove bank executive directors and even force mergers or liquidation of banks in extreme cases, the fund has recommended.

A stronghold on banks ensures the government gets to push through its social sector initiatives, the major reason for the reluctance of the state to reduce its grip on banking. But it is time for the government to adopt a hands-off approach if it wants to create future value for its shareholding. IMF certainly feels so.