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Huge public ownership in the banking system has led to the predominance of perverse incentives that have rendered the system broke. Photo: Mint
Huge public ownership in the banking system has led to the predominance of perverse incentives that have rendered the system broke. Photo: Mint

Public sector banks cannot be fixed

Given the nature of their ownership, public sector banks will remain prone to misuse by interest groups

The mismanagement of state-owned banks to serve the demands of interest groups has been in the news for quite some time now. Be it the case of loans to corporate groups with political links or the massive loan waivers to farmers belonging to strong vote banks, this has been confirmed several times. It has led many, including Prime Minister Narendra Modi, who gathered the heads of government-run banks in Pune earlier this month, to consider greater autonomy to them as a possible solution to the problem.

Yet, the question of whether it is merely their administrative status that makes public sector banks prone to mismanagement and inefficiency, as compared to their private counterparts, has taken a silent pass. Economists, however, have long emphasized the reasons for the mismanagement of public resources, as most famously elaborated by Garret Hardin in his 1968 paper on The Tragedy of the Commons.

The lack of private ownership of property—whether among few individuals or many—corresponds to the lack of incentives required for the proper management of resources. Public property is, in effect, nobody’s property. This is no less true in the case of management of state-owned banks, which occupy a dominant share of about 70% of our banking system. Huge public ownership in the banking system has led to the predominance of perverse incentives that have rendered the system broke.

For one, the management authorities of state-owned banks are expected to act like profit-seeking entrepreneurs trying to out-compete others in the market. This demand is often in vain, as bureaucrats dealing with public money cannot be expected to replicate the performance of private bankers betting their own money. The fact that basic access to banking remains a distant dream to many Indians, mostly notably in many parts of rural India, should come as no surprise.

Often, on the other hand, the managers of public assets possess strong incentives to use them to serve their personal ends. The arrest of the chairman of Syndicate Bank Ltd on allegations of granting loan extensions in exchange for bribes is a case in point. Extending the tenures of bank managers may help tackle such illegalities to an extent, but it would still not match the efficiency of a private system where the incentives to curb misuse of bank assets are much higher.

Adding to this is the fact that government control of banks essentially translates into the use of the system to satisfy interest group demands at the expense of tax payers. Farm loan waivers and corporate loans to cronies are already taking a toll on the banking system, as even Reserve Bank of India (RBI) governor Raghuram Rajan has pointed out on several occasions. The huge increase in the size of non-performing assets which currently stand at very well over 2 trillion is further testimony to this fact.

All of this, of course, should have been clearly expected, given that public resources almost always serve only the cause of political ends. Banking across the world has for centuries remained the favourite apparatus of the political class to fund their extravagance. The current excitement over granting of greater autonomy may thus fizzle out soon when reality strikes. Even if change that is significant in superficial terms happens, it would be wise to look for other means woven behind the view of the public. For often, the incentives to retain the political control of credit are too high for governments.

The only way to permanently rid the system of its perverse incentives would be reforming the ownership of public banks. This would require the government getting out of the banking sector and allowing private entrepreneurs to decide the flow of credit in the economy.

Natural Order runs every Monday, with a libertarian take on the world of economics and finance.

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