Our bank privatization agenda demands clarity

A clamour for complete privatization of state-owned banks seems to have arisen in policy corridors once again. This is not a new demand; discussions about the government liquidating its entire shareholding in public sector banks (PSBs) have taken place many times in the past, without any specific policy objectives spelt out. This time, though, the idea seems to have emanated from potential buyers of PSBs scheduled for disinvestment. If media reports are to be believed, investment banks and other likely investors, including some private lenders, have conveyed to India’s finance ministry that the Centre’s full withdrawal from PSBs would facilitate the disinvestment process and value discovery. The only hurdle is legislative: Section 3(2B)(c) of The Banking Companies (Acquisition and Transfer of Undertakings) Act of 1970 requires the government to hold at least 51% of a PSB’s paid-up capital at all times. The government will have to amend this Act if it wants to sell all its equity, and any such move is fraught with political ramifications, especially at a time when assembly elections are due in critical states like Gujarat and Karnataka over the next 12 months.

In theory, the full privatization of PSBs may not be such a bad idea. It will improve capital allocation efficiency and overall productivity by an order of magnitude. It is well known that PSBs bring down the average productivity of India’s financial sector with their slothful networks, outdated systems and stifling bureaucracy. In addition, weak incentives result in poor decision taking. New Delhi’s recent moves to create economies of scale by merging three-four PSBs into one large bank meets that objective only partially and does not address the core issues. However, talk of privatization remains irresolute because the end goal is blurry. The primary motive behind disinvestment so far has been to fill gaps in the Centre’s budget, not to achieve a step-change in the working of PSBs.

While privatizing banks could help reduce public sector dominance of our banking sector and promote allocative efficiency, India’s current state of development does make space for PSBs. They have a role to play in the ongoing formalization of credit, financial inclusion and also in providing the Centre and states with transaction processing platforms and pipelines for the delivery of direct benefits to underserved Indians. The private sector, which has brought in scale efficiencies and productivity gains, is not designed to provide these services. So, as long as the state of the economy justifies this dual existence, we have two clear pathways to extract greater efficiency and productivity. One, the government has to end its twin-track governance model for PSBs, with the regulator always second-guessing the dominant shareholder’s next move. For example, while the Reserve Bank of India (RBI) must approve the appointment of private bank CEOs, the government’s choice of chief executives is binding on RBI. Second, the Centre’s stuffing of PSB boards with party functionaries, often with scant knowledge of banking, gives rise to myriad forms of rent seeking and thereby a problem of bad loans. Given that PSBs are here to stay for some more time, we should focus on improving their standards of governance, rather than simply trying to offload them via bulk stake sales. This may help meet temporary mismatches in the Centre’s cash flows, but would miss the larger target of fostering a viable financial sector to support our economy.