Government ownership has been a factor underpinning stability in banking

As the new Finance Minister, Arun Jaitley, comes to grips with his portfolio, he will need to quickly focus on the banking sector. Today, Public Sector Banks (PSBs), which account for over 70 per cent of assets in the banking system, are bogged down by a rise in non-performing assets. This has eroded their profitability and limited their ability to raise the regulatory capital needed to make loans.

A Reserve Bank of India (RBI) committee on bank governance, headed by P.J. Nayak, has a ready solution: free PSBs from government control and eventually privatise them. It is a solution that is fraught with both political and economic risk. Mr Jaitley must steer clear of such quick fixes.

The Nayak committee’s case for privatisation rests on the presumed superior efficiency of private sector banks. It thinks that if only the government gave up its controlling function and became a passive investor instead, it would stand to make enormous returns on its shareholding.

Problems with the proposition

There are serious problems with this proposition. One, it is based on a comparison of performance of PSBs and private sector banks at a time when PSBs are weighed down by the problems of the economy at large. It would be more appropriate to compare performance over a longer period. A wide range of academic studies points to a trend towards convergence in performance of PSBs and private banks since banking sector reforms were set in motion in 1993-‘94.

Two, such comparisons are flawed by what is called ‘survivor bias’ in the private sector group. Several new private sector banks licensed after 1994 have ceased to exist. Precisely for this reason, they would not be found in the private bank group used for comparison. This lends an upward bias to the performance indicators of private banks.

Three, the comparisons ignore the scope of activities of PSBs and private banks. PSBs have an important development role. They took upon themselves the task of funding private investment in infrastructure which was an important driver of growth in the boom period of 2004-08. Private banks can be more choosy about what they wish to fund. Many are focussed on the retail segment, working capital and wealth management. Foreign banks make enormous profit out of their capital markets division alone. If PSBs were to adopt such a narrow focus, sectors that are crucial to the economy would be starved of credit.

From a flawed starting point, the committee moves on to a diagnosis and a prescription that are even more flawed. The committee thinks the PSBs are doing badly because their boards are dysfunctional. The government packs the boards with its own people. The boards go through the motions of approving proposals put up by the management. Little thought is given to issues of strategy and risk management. In contrast, private banks have high-quality professionals on their boards that provide sage counsel. This, the committee contends, is what explains superior private sector performance.

The solution? The government should distance itself from bank boards. The committee wants government shareholding to be transferred to a Bank Investment Company (BIC). The Bank Nationalisation Act and other related Acts must be repealed and PSBs brought under the scope of the Companies Act. The BIC would appoint members of boards of PSBs as well as their CEOs and executive directors. It would let its stakes in PSBs fall below 50 per cent so that banks are freed from limits on remuneration, the Right to Information Act and the jurisdiction of the Central Vigilance Commissioner.

Freed from these vexations, the PSBs can single-mindedly focus on profit maximisation. Eventually, the BIC would transfer its ownership powers to the bank boards. The government’s stake in the BIC itself would fall below 50 per cent, thereby privatising these banks. We would enter a brave new world of Indian banking liberated from the stranglehold of government ownership.

The committee’s faith in the functioning of private bank boards is truly touching. If boards in the private sector are such paragons of virtue, the committee must tell us why some of the biggest banks in the U.S. and the U.K., whose boards were packed with glittering names from the corporate world, collapsed in the financial crisis of 2007.

To cite only one example, the U.K. regulator, the Financial Services Authority (FSA), looked into the collapse of the Royal Bank of Scotland, the biggest banking failure in the country’s history. Its report noted that there was an almost complete lack of questioning and challenge on the part of the board in the critical years when the bank hurtled towards ruin. There was nothing wrong with the composition of the board.

Boards in general are dysfunctional, whether in the private sector or the public sector. The remedies must, therefore, be generic in nature. The Companies Act 2013 and clause 49 of Securities and Exchange Board of India’s listing agreement now contain clauses that are intended to improve the functioning of boards, in particular, that of independent directors.

In banking, the regulator needs to go further. ‘Fit and proper’ criteria for board members must be strengthened and the RBI might adopt the FSA’s practice of interviewing candidates proposed for a directorship on a bank board. For banks above a certain size, there could be a requirement that positions be advertised and nominations sought from eminent persons so that a wide pool of talent is tapped. The RBI may stipulate that bank boards contain expertise in areas such as risk management and marketing of financial services. Board effectiveness could be measured using outside experts.

These measures would help strengthen boards. We must recognise, however, that there is only so much that boards can contribute. It is the quality of management that is crucial to performance. In PSBs, this must be the government’s responsibility.

The government does not have to discharge this responsibility through diktat from the finance ministry. It can operate through its nominees on the board. The government nominees and the RBI nominee on PSB boards must ensure that there is proper succession planning and that managers are groomed for various levels of leadership.

Opposing privatisation

It is unlikely that the Nayak committee’s proposals will go through in the near future. Political parties and trade unions will oppose any move towards privatisation. This will make the repeal of various Acts difficult, given the present composition of the Rajya Sabha. Selling government stakes in PSBs without turning them around is bound to invite accusations of a ‘scam’. No government can risk distancing itself from control of PSBs and handing over these to a group of professional managers at a time when banks are severely stressed.

That apart, we need to be clear about the basic rationale for government ownership in banking in India. There is more to it than the larger social purpose of banking. Our experience has been that government ownership has been a factor underpinning stability in banking. The world over, economies have faced banking crises over the past several decades. Banks failed, they were nationalised or bailed out, then turned over to the private sector. This is the phenomenon of socialisation of losses and privatisation of profits that has come to attract public outrage.

India’s experience has been refreshingly different. The Indian approach has been to have the public sector dominate banking while exposing it to competition. In the process, efficiency has improved without jeopardising stability. Experience has shown that it is possible to retain the public sector as the sheet anchor of the banking system without compromising on efficiency.

Addressing the issues of governance at PSBs requires focus on the part of the finance ministry. Mr. Jaitley doesn’t have to look very far for inspiration. One of Narendra Modi’s less heralded achievements as Chief Minister of Gujarat was his success in turning around state PSUs by professionalising their boards and giving management a free hand.

(Ram Mohan is a professor at IIM Ahmedabad.)

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