Beasts Of Burden: Here's How The Broken Public Banking Sector Can Be Fixed

India’s aspiration and latent economic potential cannot be funded by the current set of PSU banks and NPSBs. Here’s how the government can fix the broken banking sector in India.

Notwithstanding our touristy ads, India is a poor country. Public finances are derived from our poor denizens. Indirect taxes this year constituted over 45 percent of our total tax receipts whose burden falls disproportionately on the poor. As such, it is a moral responsibility to ensure the Consolidated Fund of India is utilised with humility, wisely and well.

The Indian banking sector is overwhelmingly owned by the Government and by extension the Indian citizens. The government has invested crores of rupees till date as capital/retained earnings in the public sector banks. But all measures of efficiency and effectiveness like return on assets, NIMs (Net Interest Margin), employee productivity, NPAs (Non-Performing Assets) etc. are sad, to say the least.

NPAs are variously estimated to be between Rs.6 lakh crore and Rs.12 lakh crore (about $100 – 200 billion). NPAs are a part and parcel of the business of banking, one cannot banish it by fiat.  NPAs are a result partly of business conditions and frequently the incompetence and immoral behaviour of company promoters and bank management. The governance failure in India means that borrowers default on loans with impunity with nary a fear of consequences. There is repeated ostentatious borrower behaviour while the state and public at large is a mute spectator to these excesses while the might of the entire state descends on an unfortunate individual borrower defaulting on say her only mortgage. Accountability has almost never been established even though the plunder of public banks by many reputed business houses aided by pliable retiring bank executives is common knowledge.

Rather than action to disgorge ill-gotten wealth, we repeatedly watch public exhortation by the highest office bearers of the land (the PM and the FM among them) urging banks to make “easy” loans to kick-start the economy and egging these same severely, cripplingly, indebted business houses to borrow and invest.

Be that as it may, the poor Indian citizens, with an average per capita annual income of under Rs.1 lakh never signed up to take on the risks of commercial banking.  They do not have an understanding of the business or social or moral hazards involved in the banking business.  As custodians of public money, it is the responsibility of the Indian government to shield the poor citizens from multitudinous risks rather than subject them to such complex ones. Repeated cycles of bank losses, recapitalization, further loan book expansion, eventual NPA, losses etc. has a ruinous impact on public finances.

As a poor, capital starved economy, there are a host of necessary, desirable and indeed essential projects that are shelved and postponed for want of capital while the urgent squeals of the regulator and financial media leads to funds being diverted to bank capitalisation (through accounting gimmickry and sleight of hand means like investing in capital and having the bank buy long dated government bonds instead).

The PJ Nayak Committee in 2014 delved into this problem and suggested many changes (with the usual timid multi-phase approach) little of which has been implemented so far.

The large sprawl of about 29 public sector banks (and 6 State Bank and group banks) and thin central government (owner) supervision means that we have a never ending series of spectacular bank losses with unerring regularity. The regulator puts them into the straight-jacket of narrow lending for years on end, till they meander to a less critical state many years later or a bigger problem case erupts. The government must desist from all kick-the-can-down-the-road actions like insufficient recapitalisation, regulatory forbearance on restructured assets, improper managerial oversight, inordinate delays to let the problem fade etc.

Outright Privatisation, the obvious answer is apparently not even being considered as it may be unattainable.

To begin with, the government should proceed with the long dreamed bank consolidation plan and collapse the system into a handful of banks, say no more than 5 (even though this will reduce the gravy train of arbitrary appointment of incompetent but loyal followers to bank boards). This can be done in one fell swoop, within one budget cycle through the creation of NEWS Banks (North, East, West, South plus the State Bank Group). I expect the synergies arising out of merger (through branch rationalisation, bloated/dysfunctional management layers being shed, head office rationalisation, scale efficiencies and hopefully better credit decisions) to be in tens of basis points.

Next, keep an eagle eye out on the management of these few banks or pass the task on to a professional “Sovereign Wealth Fund” (e.g. GIC, NBIM) or a “Bank Investment Company” as has been suggested.

Housing service-providing companies inside parent ministries is a sure way to forget the original mandate to ensure service provision for the citizens rather than perpetuate service providing entities.  So, the ownership of PSU Banks should be divorced from Finance Ministry as soon as possible.  The idea is to improve Return on Capital and dilute Indian public shareholding over time as best possible.  Improved governance and pursuit of big “wilful” defaulters to make a statement of intent would be desirable.  As the Chinese premier recently famously pronounced, the ill-doers in the system must be made to fear.

The New Private Sector Banks (NPSBs) introduced through the 1990s have done well.  Their call on government capital is negligible (in fact they are regular and significant tax payers), their talent and processes are more advanced and the result is visible in terms of their ability to largely side-step the crippling NPAs burdening the public sector banks. And therein lies the lesson. The advent and early success of NPSBs has reduced the banking market share of PSU banks from about 80 percent in 2000 to 73 percent in 2013.

Government and RBI must now make haste to make the PSU banks irrelevant.  Government/RBI should focus on measurable goals like reducing PSU market share to between 25 percent and 33 percent in 10 years’ time.

The current glide path will only take this share down to 63 percent by 2025 which will keep Indian economy resource starved and push the government finances to the brink. India’s aspiration and latent economic potential cannot be funded by the current set of PSU banks (and its resource starved Government ownership) and NPSBs.  It’s time for the government and RBI to dramatically hasten competition in the private sector through grant of open, transparent licenses in large numbers.

At the same time foreign banks must be unleashed in India through the grant of hundreds of branch licenses annually to large reputed well capitalised foreign banks (rather than the single digit licence currently being dispensed) tied to minimum capital requirement per branch and a WOS (wholly owned subsidiary) structure.

This can lead to a huge positive surge in FDI inflows (just like the increasing investments in insurance companies), leading to better competition, advent of technology, management and risk practices.  It would not be a bad idea to see market share of foreign banks increase from about 4 percent to about 25 percent.  Capital is then likely to be more easily available to economic players on better terms and more suitable structures.  Innovation is likely to be fostered.  Payment bank is but one small timid step into this future.  The above changes would not require legislative intervention and can be carried out between the RBI and the government by simply expanding the current rate of approvals.  The experience of PSU, private sector and foreign players competing in telecom, oil and gas, ports and other sectors is positive.

PSU banks, NPSBs, new banks and foreign banks should be allowed to compete and make capital available to the diverse players in the economy.  They should be free to make big profits in the process (after following extant rules and paying due taxes to the exchequer) or make losses in their business and see their equity wiped clean.  Either way, the small farmer or unorganised sector worker should not be made to pony up taxes to fund the bank recapitalisation-NPL-losses cycle.  Monies from Consolidated Fund of India would be better spent on other essential public goods.

Of course this would not be easy. Narrow, vested interests will do everything to derail even small steps.  Witness the easy capitulation on IDBI reforms following relatively minor protests. But these changes are necessary.  Banking sector cannot be allowed to be the yoke dragging the Indian economy down, nor can India afford to provide the capital needed to keep PSU bank market share at current or somewhat lower levels.  Dramatic action is needed.

Fortunately, India has recently tackled an apparently insurmountable subsidy problem in the Oil and Gas sector even before the dramatic oil fall. That ought to give confidence that even major, insurmountable challenges can be tackled if there is adequate political will.  The large election mandate and bold vision of the current leadership should be directed to make far reaching changes to realise the great Indian dream.