Thursday, 24 January 2013

Bank for the buck

This year the government will put in Rs 12,500 crore for recapitalising public sector banks. Year after year, the ministry of finance puts more money into PSU banks. To expand banking in India, the government has chosen a two-pronged approach: putting more money into public sector banks while giving new licences for banking to private companies. In the present Indian system - with its lack of transparency, absence of the rule of law and pervasive corruption - a better policy to expand banking in India would be to divest public ownership of banks and convert them into widely held private banks.

Such a policy would address some of the RBI's concerns about industrial houses owning banks, limit the use of taxpayer money to support inefficient banks and give the country a competitive banking system. India's experience with public banks that have become widely held private banks, such as HDFC and ICICI, has been better than with new private banks, where family-dominated firms obtained licences.

Policy-makers in India like to claim that we have not had a banking crisis for a while. This claim is called into question when we witness the stream of money that has gone into PSU banks. Almost every year over the last two decades, the government has injected taxpayer resources into PSU financial firms. If we had done a recapitalisation of Rs 100,000 crore at one shot, it would have been obvious that there were big failures of financial regulation and policy. But when we dribble it out as Rs 10,000 crore per year for 10 years, it is not seen as rescuing a failing financial system.

PSU banks are not profitable enough to grow on their own steam. This reflects the failure of bureaucrats as bankers. Normally, profits are reckoned after paying for bad loans, and retained earnings are ploughed back into the equity capital of the bank. The equity capital with a bank determines how much of deposits it can take. A PSU bank that does not have equity capital will be forced to not take more deposits from the public. This constraint does not bind it as much as it should, as the RBI has often been lenient, tolerating the inadequacy of equity capital.

Indian banking has been rigged in favour of PSU banks in numerous ways. The RBI has blocked the entry of foreign banks and new private banks in an attempt to protect the cosy domination of PSU banks. A man who deposits money in a PSU bank knows it has the backing of the government. This is not the case with their competitors, and that helps increase the market share of PSU banks. Despite these violations of competition policy, PSU banks have failed to be adequately profitable. This makes them go back to the finance ministry for more equity capital.

At present, we have a finance ministry that is tightfisted when it comes to putting equity capital into PSUs owned by other ministries and discusses disinvestment of its holdings, but it is willing to put in additional capital when it comes to banks that are in its domain. The finance ministry needs to be as sceptical about putting equity capital into PSU banks as it is about putting equity capital into any PSU. If Air India does not get money, why should the SBI?

India is in a dire fiscal crisis and every single opportunity for cutting expenses should be harnessed. Even if there was money available for spending, it has better applications. In recent years when we have typically been lavishing Rs 10,000 crore every year into PSU financial firms, India would have done better if this same Rs 10,000 crore had been spent on building 2,000 kilometres of highways, or a metro system for a mid-size city like Nagpur.

A better option is to dilute government ownership in PSU banks and allow them to run and grow as normal private banks. In 1969, when banks were being nationalised, Indira Gandhi's economic policy team thought it was wise for government to have 51 per cent ownership of PSU banks. We have reversed almost every element of Indira Gandhi's economic policy framework, and this should be no exception.

We have two successful privatisations of PSU financial firms before us: HDFC and ICICI. Both were once controlled by the government and both are now dispersed shareholding companies. They were not sold off to some family, they became modern corporations. This roadmap - building dispersed shareholding private companies that are controlled by no family - should be followed for all PSU banks. This will require carrying legislation through Parliament, and it would make good use of the scarce political capital that the UPA possesses.

The government has made a case for giving out new licences for private banks. The RBI has rightly expressed concerns about banks run by industrial houses. In the past, Indian banking has suffered as the mechanism to prevent theft of depositor money by private banks lending to their business interest has been an issue. Banks must be dispersed shareholdings with professional managers - as is the case with ICICI or HDFC. In an ideal situation one would argue that the banking regulator should give licences to firms that it deems fit to run banks, but in today's India, most people, and perhaps the regulator itself, is correctly concerned about the political pressure that may be brought to bear on the regulator if it opens up the gates to new private bank licencing. It would be wise to gather experience with enhanced supervision of lending to conglomerates before venturing to give bank licences to large industrial houses, who are often the ones with the money to apply for such licences. As the recent IMF financial stability assessment report also points out, in the current context, the risks of this policy may outweigh its benefits.

Another option to expand banking in India is to open up the sector to the entry of foreign banks. At present, India limits foreign banks, in all, to 18 bank branches per year. A much more open policy framework is required, through which foreign banks can build subsidiaries in India, who are then regulated by the banking regulator on the principle of ownership neutrality and given national treatment, including the lifting of all restrictions on opening branches.

The government should consider these policy options more carefully to give India a safer and more competitive banking system.