Home / Industry / Banking /  Rajan, Viral call for a major overhaul of banking system

Former Reserve Bank of India governor Raghuram Rajan and former deputy governor Viral Acharya have called for winding down of the department of financial services, privatization of state-owned banks and creation of a bad bank as part of the reforms for India’s banking industry.

The current status quo is untenable and there is a need for reforming the banking industry so that it does not become a drain on government resources but an engine of growth, Rajan and Acharya said in a research paper titled Indian Banks: A Time to Reform, released on Monday. This is more so because of the enormous strain on government finances from the slow growth pre-covid and the subsequent effects of the pandemic.

The transformation of the banking sector will not happen through incremental reforms. “The status quo is fiscally untenable," the paper said. The covid-19 pandemic is likely to increase loan losses greater than what the government can pay, it said.

The reform of public sector banks (PSBs) in the last six years by the Union government led by Prime Minister Narendra Modi has been a still-born effort, the authors noted. The failure in implementing the P.J. Nayak Committee report in 2014 or the suggestions made at the Gyan Sangam in early 2015 to set up the Banks Board Bureau for appointments, show lack of steady political support, they said.

The government gets enormous power from directing bank lending, the paper noted. This is exercised to advance public goals such as financial inclusion or infrastructure finance and is sometimes used to offer patronage to, or exercise control over, industrialists, it said.

“Winding down the department of financial services in the ministry of finance is essential, both as an affirmative signal of the intent to grant bank boards and management independence and as a commitment not to engage in ‘mission creep’ when compulsions arise to use banks for serving costly social or political objectives," the paper said.

The former central bankers also noted that the government gets access to an enormous amount of sensitive information through its state ownership. This is evident as the identity of purchasers of electoral bonds is known only to the State Bank of India.

The paper suggested several measures to improve the performance of state-run banks but noted that many of them have been made by committees such as the Narasimham and Nayak panels. However, it called for improving the operational performance of banks through the creation of a holding company structure and incentivizing senior management with better pay and longer tenure.

The paper also recommended the dilution of government stake in PSBs to below 50% along with reprivatization of these banks by bringing in private investors and automatic dilution.

“Our proposals, taken together, will move the needle significantly on Indian banking. They are not, however, revolutionary… There are strong interests against change, which is why many would-be reformers are cynical… We are more optimistic that a middle road is achievable, given that the greatest stumbling block has been the government, the bureaucracy, and the interests within it," the paper said.

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