Former Reserve Bank of India (RBI) governor D. Subbarao, in an opinion piece that appeared in The Indian Express, has raised the question of whether India needs public sector banks at all in this day and age. He argues that the country’s financial sector in general is now “wide enough and deep enough to take care of financial intermediation", the key role of banks, without state support. This takes our national debate on the state’s role in the banking sector toward complete privatization, marking a departure from the current consensus that advocates a reduced role for the state, but stops short of that. Bank nationalization in 1969 did indeed push lenders to fan out across the country and offer services to the needy, but state dominance of the sector has also kept competition levels relatively low, necessitated micro-management by its regulator, resulted in poor lending decisions, and caused other market distortions. So, is it time to privatize banks and give market forces a better chance to prove their efficiency in the allocation of credit? Subbarao wonders if this is an idea whose time has come. So should we all.
Right now, banks are largely expected to do as they are told. Take RBI’s move last week directing commercial banks to link their loan rates with its repo rate or other external benchmarks. The regulator wants the benefits of its rate cuts to be passed on by banks to their customers. In a truly free market, such orders need not be issued. Competition for loan customers would not let a bank keep its lending rates higher than necessary to cover costs and squeeze out some profit. As for its own cost of acquiring money to lend, likewise, rivalry for deposits and other funds would mean a bank paying as much as it could afford to. The best way to gain an edge in a competitive market, banks would find, would be to crush their own operational expenditure and turn efficient. In India, state lenders are under little pressure to do this, and while the entry of private banks has upped service standards and wrought some changes, the sector is saddled with dud loans, inefficiencies and heavy cost burdens. It does not help that high state-controlled rates of interest on small saving schemes attract a big chunk of people’s savings, leaving lenders either short of money to lend or paying too much for deposits, which makes it hard for them to offer cheaper loans.
While freeing savings rates of state control could help address the problem of policy rate transmission, the sector’s health requires banks to assess and price risks properly, which needs bankers to act diligently in the interest of profit-seeking shareholders. This would be better enabled by privatization. It is not an open-and-shut case, however. The state’s exit could result in foreign equity control of banks and possibly even a loss of sovereignty over a sector that is vital to the economy. Also, since large banks would be “too big to fail", the government would still need to bail them out in case they approach bankruptcy. This would involve public funds and amount to socialization of losses, an ethical hazard if the profits had been private. To avert such an outcome, close regulation would still be needed, and if that is the case, the state could argue it needs to retain ownership control as well. Clearly, the debate on privatization needs to take varied perspectives into account. In the meanwhile, let’s at least have the appointment of public sector bank chiefs freed of state control.