The nearly $2 billion fraud at the Punjab National Bank (PNB) last month has renewed calls for privatization of state-owned banks. The managerial argument for privatization is it would make for more prudent decisionmaking, increase accountability to shareholders, reduce complacency in management, improve profitability and end political influence in business decisions.

Let us examine these arguments in detail. First, the alleged fraudulent transactions at PNB reflect lax operational controls, poor risk management and regulatory failure. Gordon Gekko’s famous quote that “greed is good" in the film Wall Street should, however, caution us against an unthinking push to privatization. Privatization, without strengthening regulatory controls and improving governance, won’t prevent fraud, or curtail undue exposure to risk. Indeed, it was the reckless approach to risk-taking by large private-sector banks that ultimately led to the collapse of Lehman Brothers in 2008 and exacerbated the global financial crises.

Second, it has been argued that state control encourages management complacency as managers are secure in the knowledge the government will always come to the bank’s rescue if it is in trouble. But is ownership the sole criteria for government intervention? Governments have in the past bailed out banks that were considered “too big to fail", regardless of ownership, to prevent a systemic collapse. Freddie Mac, Fannie Mae, Royal Bank of Scotland, Bradford and Bingley and Fortis—all came close to going bankrupt during the global financial crises and had to be rescued using tax payers’ money. Arguably privatization in some instances led to privatizing profits and socializing losses. If PNB or the State Bank of India were privately owned, would the state allow these banks to fail?

It has also been suggested that privatization makes management more accountable to markets, but these state-backed banks, having been partially privatized following the 1992 banking sector reforms in India, are already subject to stock-market discipline—including corporate disclosures and regular audited financial reports.

Another argument by advocates of privatization is it would foster increased competition, which would reduce the cost of financial intermediation and improve bank profitability. Yet again, it is unclear how a change in ownership from government to private hands would increase competition if the number of participants in the industry remain the same. Indeed, there are plans afoot to consolidate state-run banks, bringing down their number to about 15 from 21. Fewer but stronger banks could, however, provide more effective competition than a large number of weak banks.

The strongest case in support of privatization is that state-backed banks are hobbled by bureaucratic restrictions and undue political interference, making the sector susceptible to elite capture. As the experience with Air India has shown, political meddling can seriously hamper performance at state-run companies. Indeed, it has been said that India’s mounting bad debt problem may be partly a reflection of crony capitalism where political considerations may have forced the hand of bankers to extend credit to several powerful business houses who have since defaulted.

While political influence in extending credit to these large businesses may be true, it is difficult to prove without forensic evidence. What is clear, however, is that regulatory intervention over the past several years has forced banks to disclose their bad debt portfolio with consequent losses at state-owned banks. Indeed, the escalating bad debt problem is partly a reflection of overenthusiastic lending by banks to industry during boom years that came to light after the Reserve Bank of India forced the banks to declare their bad debt portfolio. Research by Credit Suisse in its highly regarded series “House Of Debt", has tracked the weakening financial performance of 10 heavily indebted Indian conglomerates. These companies were caught in a debt trap despite attempts to sell assets, driven by turbulence in global commodity prices and a weak domestic economic recovery. Private banks too have incurred slippages but the magnitude of the loss is much less, thus making a case for privatization. On the flip side, however, a handful of large private banks can also engage in state capture—defined as the propensity of firms to shape the underlying rules of the game by purchasing decrees, legislation, and influence at the central bank.

Finally, it must be remembered that state-owned banks in developing countries have an important social objective—to meet the needs of the most vulnerable sections of the economy. Though both state and private sector banks are required to lend 40% of their loanable funds, at a concessional rate, to the priority sector, the main burden of the government’s development policies—from rural lending to infrastructure development—falls on state-run banks given that they are dominant players in India’s banking system.

Public or private ownership, both can be equally good or equally bad. It is the institutional factors that determine managerial success. In the case of banking, what is needed is increased autonomy for state-backed banks and strict regulatory oversight by the banking supervisor. The boards of state-backed banks should be independent of political influence. Managers should be held accountable for operational performance and there should be constant monitoring of targets, risk assessment and credit controls. The clean-up of bank balance sheets and the overhaul of India’s archaic insolvency law are steps in the right direction, but they will only bear fruit if accompanied by improved governance and regulation.

Indrani Dattagupta is a financial journalist.

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