Privatize public sector banks to prevent future Nirav Modis

The latest scandal involving Punjab National Bank (PNB) and jeweller Nirav Modi is the newest symptom of an old malady—the government owning and running banks in India. PNB is not the first public sector bank (PSB) to lend into a hole, and it certainly won’t be the last.

Though there are multiple failures when the hole in the wallet is as large as Rs11,000 crore, almost all these failures can be linked to the fundamental problem of the government owning banks. PSBs are not run like private businesses, which have a residual claimant who either profits or bears the losses. There is no residual claimant in a PSB and the competition in the marketplace becomes irrelevant when there is a soft budget constraint because of the implicit sovereign guarantee. This leads to three specific incentive problems.

The first incentive problem is that employees of PSBs are rarely promoted based on performance, or fired for non-performance. In a world where future prospects are based on seniority and age instead of merit, there is little incentive to make good decisions. In a privately run bank, mispricing loans would lead to losing one’s job, and taking sensible and calculated risks would lead to praise, bonuses and promotions. Both the stick and the carrot are missing in PSBs. The result is a culture where employee interests and actions are not aligned with the bottom line. The PNB management has pinned the entire blame on two employees, a deputy manager and his subordinate. If true, this raises many questions. How many employees were asleep at the wheel for a fraud of such magnitude to unfold over six years? Who hired the concurrent auditors for this bank branch, and who were these auditors, and what were they doing?

Second, the management at PSBs has little incentive to implement systems that flag and prevent fraudulent actions by employees. The management is never rewarded for its profitability or replaced when the bank incurs losses. They are selected and appointed by a group of mostly partisan non-bankers through the department of financial services. Management positions in PSBs are also not paid comparably to private sector positions. Is it any surprise that these relatively poorly paid bureaucrats with no incentive failed to install a system of checks and balances?

For instance, an integrated banking system makes it easier to detect fraudulent transactions or when employees overstep their lending parameters. PNB, it seems, did not adopt the new and sophisticated core banking systems that maintain details of daily banking transactions and update accounts and financial records. A fraud that began in 2011 was only reported in January 2018. Even basic checks, like linking the SWIFT system to the existing PNB system, are missing. It is rumoured that an updated core integrated system was sanctioned for PNB in 2002, but it has still not been implemented. Investors and taxpayers may have lost Rs11,000 crore because PNB management didn’t think to buy the latest software.

Private banks in India have updated to core integrated banking systems that can detect transactional discrepancies. They have several checks and balances, especially for large transactions that are signed off by a few employees in sensitive positions, and have prudent practices for pricing loans for risky businesses, and lending to large borrowers. And none of this is a secret. Indian technology companies consult in India and the world over to build software solutions for banking systems. Only PSBs are slow to adopt these platforms. Private banks have an incentive to be careful while lending their money since they are directly accountable to depositors, owners and shareholders. PSBs, on the other hand, are spending taxpayers’ money—a limitless resource to cover all mistakes.

The third problem is the incentive for the custodians of PSBs—the politicians in power. These banking scandals almost always involve PSBs for an important reason. Politicians have an immense resource at their disposal—the ability to arrange cheap credit for risky businesses in exchange for campaign finance. They leverage this resource and pass the bill to the taxpayers. Hard and soft political pressure is applied to instruct bank management to accommodate well-connected businessmen. It is no surprise that politically connected conmen like Nirav Modi approach PSBs. Private banks are much too careful to lend to such poor and risky businesses. But even PSBs with honest employees may have no choice but to follow the orders issued at the top. One should expect many more Nirav Modis to come out of the woodwork. While a fraud of this magnitude is an outlier, PSBs are a mess because of the smaller bad loans issued to many politically connected businessmen.

These problems cannot be solved by regulation or reform or recapitalization. The only way to prevent this in the future is for the government to sell PSBs and exit the banking business. When faced with crisis, Prime Minister Narendra Modi tends to point fingers at past governments. Here, he has a clear target—Indira Gandhi and her colossal mistake in nationalizing the 14 largest banks in 1969 and creating a soft budget constraint for banks. Post-nationalization, the once formidable banks have been run down into a mess where a businessman and two employees can swindle Rs11,000 crore. Today, all 21 PSBs put together have a market capitalization that is less than that of HDFC, India’s largest private bank.

This is a good time for the government to blame Gandhi’s excesses for the mess, and reverse the bank nationalization policy by selling the government stake in PSBs and exiting the banking business.

Shruti Rajagopalan is an assistant professor of economics at Purchase College, State University of New York, and a fellow at the Classical Liberal Institute, New York University School of Law.

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