Calibrated approach to bank privatisation needed: Industry leaders

The government sounded the bugle on privatisation of state-owned enterprises in its recent Budget. Should public sector banks be privatised as well? What is the way forward, and how soon can this be achieved? In November 2021, “Bank privatisation: Undoing 1969”, brought together some of the best minds — former RBI deputy governor SS Mundra; former SBI chairman Rajnish Kumar; BCG India Chairman Janmejaya Sinha; and former secretary to the Government of India KP Krishnan — to debate the issues. Edited excerpts:

What was the purpose of bank nationalisation, and has it been served?

Janmejaya Sinha: In 1969, banks were nationalised because India was a basket case, no one was going to lend us money. The only way forward was to raise deposits from all Indians and use them for development. After 1992, when private banks were allowed, efficiency in the industry increased. There are issues that create impediments in the functioning of public sector banks. They are in governance, recruitment and the inability to take decisions because of oversight. I do not believe in full privatisation of the sector, though I am a strong advocate of the government being the single-largest owner in a set of banks, with a stake of below 50 per cent. We should have private banks, foreign banks and new banks join this segment to keep the vitality alive. You don’t need 20 public sector banks, so privatising some banks is a good idea.

Krishnan: The nationalisation of banks was primarily a political move. Given where we are today, the attempt going forward has to focus on efficiency, and hence the scope of much greater private participation is huge. But since we are not starting on a clean slate, we do not completely denationalise. We overwhelmingly privatise and see how the situation evolves. Post-1992, India has taught us the power of a deep private market in finance. The combination I will push for is good-quality, well-executed regulation in a sector which is primarily private.

Kumar: One achievement that India can be proud of is the reach of public sector banks. Would it have been possible to have this reach with only private sector banks? No, because, even today, the services of private sector banks have a certain exclusivity and their price puts them beyond the reach of the common man.

The RBI’s stance on ownership is neutral. There is no regulatory differentiation and the standard of governance they expect is identical for both public and private sector banks. On the negative side, there are a lot of rigidities and inefficiencies that have crept into the system — the board-level quality, continuity at the management level, management quality, rigidity in compensation structure, HR policies, and obligations that arise because of government ownership. So, it has been a mixed bag.

Today, enablers have been created to bring banking within the reach of the common man. These are technology and the business correspondent model which was adopted sometime after 2007 or 2008. Riding on these two, the banking system is in a position to provide banking services at a much cheaper cost than earlier. Digital is a great leveller. We can confidently debate whether we need banks in the public sector.

Mundra: The stated objectives of nationalisation included three key aspects. One, the major credit of banks is going to crony capitalists. Two, banking was not reaching the common man and third, the farm sector was completely left out. Today, credit allocation going to a particular sector is no longer relevant. Retail credit in India’s banking sector has exceeded credit to the industrial sector for the first time. The sector has opened up and we have private banks, NBFCs and fintechs.

One cannot say that reaching out to the common man can only be achieved through a government-owned bank. Fintechs in collaboration with banks are offering very interesting solutions for providing farm credit. The argument on privatisation is advanced mainly on two counts. That it brings greater efficiency in the system, and that the government has constraints when it comes to providing capital to banks.

On efficiency, there are public sector institutions globally which are as efficient as any private institution. So, it is well established that efficiency is management-neutral. What banks need today is not just the minimum required capital to keep them afloat. They need growth capital. This capital can never come from profit alone. Today, banks are morphing into fintech entities, and to bring the right talent they need to cast their net wider and provide continuity of leadership. These are constraints that come with government ownership.

What should be the extent of privatisation for banks?

Kumar: A beginning has been made and banking has been declared a strategic sector, in which the government has said there will not be more than four entities, with the rest in the private sector. We have to see how it progresses. India is a much more mature and open economy today and the public sector is not seen at the commanding heights of the economy. There is a lot more acceptability to privatisation. In 1991, when economic reforms were initiated, there was scepticism about privatisation, but we have seen the benefits.

What we are today is because of the reforms initiated in 1991, and India is currently a much more confident economy. Things have changed because of the IT sector, which I consider to be India’s singular achievement. India is among the leading nations as far as the fintech or startup universe is concerned. We are at the forefront of technology change and in such an environment, why should ownership be with the government? What specific objectives do we want to meet?

If we talk about the flow of credit, things are changing, because the models are changing, with AI (artificial intelligence) and machine learning-based models coming into the picture. We are seeing a shift where banks’ corporate credit share is reducing, which is the trend globally. For most banks internationally, 50 per cent is the mortgage and that is where India is moving, because the economy is growing and the middle class is growing. The banking system today is capable of delivering services to every corner of the country, riding on technology and the business correspondent model. So, the key question is, why do we need the government as the owner of banks? 

Mundra: Something that has been created over a period of decades cannot be unravelled in a hurry. It is anybody’s guess whether the government is going to exit lock, stock and barrel in a hurry. I don’t think it would be a good thing to do. Banking is a very important institution and you can’t experiment with it. At the same time it is nobody’s case that you must have 20 identical banks doing the same things. From that point of view, consolidation was the right thing to do. You avoid duplication of resources.

Now, you have three or four possibilities. Is privatisation the only answer to achieve efficiency, governance and capital? There are several unknowns and this is not an area where you can make drastic experiments. But given the possibilities of today you can try three or four use-cases simultaneously. Even if we are moving towards privatisation, it is going to be a decade’s journey. It is not going to happen in a year or two. You have one large consolidated bank. Now, after the consolidation would you like to divest it? If you want to divest it, will you find an anchor investor?

Post-1991, many of these banks already have public holdings of 45 per cent or more. So, in some sense, the banks are part-privatised already. Now, if you have a consolidated bank which is 40-45 per cent widely held and if you have to privatise this bank, would you hand over a bank of such large reach and systemic importance to a core investor? Will you be able to find a core investor that will meet the fit and proper criteria of the regulator? These questions need to be addressed.

The other approach is, can you directly take this bank to a widely-held model? That may be fraught with too much danger unless you address the issue of the structure of corporate governance. But there is a possibility. In the second model, you pick up a smaller bank, the government can still retain 49 per cent, allow the majority holder to be a core investor, and see how it goes. If you are divesting a consolidated bank you remain at 26 per cent, have a widely held position and also bring a core investor. But when you are doing all this, it is still important that you go to the bank holding model.

There is one more case which is not governed by the nationalisation statute, which is already in some sense privatised. That is the most ripe and low hanging fruit which can be taken to the full extent of privatisation with minimum difficulty. Three models can be used in only three use-cases. But for the fourth model you have to create a bank holding company, create separation of ownership with the bank management, and then create a road map of 10-20 years to dilute the ownership at the entity level and at the “holdco” (holding company) level.

Krishnan: The government is sincere in its desire to privatise banking, but it is not in the interest of the system to do it at one swift go. Therefore, we should in parallel be working on a bunch of amendments to the Bank Nationalisation Act, because that Act was written in 72 hours. It is an exceptionally badly written Act. The kind of controls it has on a public sector bank manager can be easily sorted out and can be moved to the IDBI-type model — a corporate bank much more driven by the corporate board. The government will need a plan A, B and as Mr Mundra said, a plan D.

Sinha: We are unwinding a system and we want to bring in greater efficiency, yet we want stability. We need accentuated regulation, which can ensure that you don’t have a collapse. And we have seen in markets across the world that private banks have collapsed. Regulation needs to run ahead. Given the speed with which technology is evolving, the nature of the risks coming in, the pressure on the regulator is quite high. So, to have a stable system, we should not ape other countries. 

India is a project finance economy, while the US and other developed countries are working capital economies. When we talk about the difference between a private and public institution, we say the incentives are higher in a private institution. But this is bunkum. You can actually work out the payment structures if you have enough freedom to create those incentives. You can say the goal clarity is better in private institutions. Well, you can give that same goal clarity in public institutions. So, the problems of each of these structures needs to be identified. And then we need to ask ourselves if the government is willing to bring in this change and to bring themselves below a certain threshold and give autonomy.

And if we believe that the government will not be able to resist the urge to interfere, then we know we need to create enough entities in the private sector to put pressure on these entities, so that they are compelled to perform. So, we need to be thoughtful in this journey ahead, we cannot throw the baby out with the bathwater. We need to create efficiency with more governance and greater autonomy. And the regulators will need to raise their game, otherwise this cannot really happen.

Is regulation ownership-neutral, and is the government willing to give up its rights for privatisation?

Krishnan: Look at the Act of 1970. Restrictions over issue, restructuring and reduction of capital, limits on exercise of voting rights, restrictions on foreign ownership, mandatory agency relationship with RBI and section 9 (3) on board composition. In a legal sense, I wouldn’t say that it is ownership-neutral. The RBI’s regulations in terms of how it approaches these questions may be ownership-neutral. But the legislative frameworks are not ownership-neutral.

Operationally, many of these problems can be sorted out easily because half of these have never been used. Even a minor clean-up of the Bank Nationalisation Act can help achieve a higher degree of ownership-neutrality, and that may be a good route to eventual privatisation. The most difficult thing is to give up ownership and you have an explicit speech of the finance minister in the Budget, talking about privatisation of banks, which is the furthest that we have come from 1969.

Sinha: If you first corporatise these banks, take them out of the (Bank) Nationalisation Act and bring them into the Companies Act, you take out a lot of existing perversions. The finance minister mentioning privatisation in the Budget speech (of last year) is a very big statement. Let’s not underestimate that statement itself. Listing LIC, privatising two national banks is a big deal. Consolidation was easier. However, doing it in the current construct will take great effort and tenacity.

Mundra: As the current structure stands, I won’t agree that regulation is ownership-neutral. If you look at recent history, we have reasons to believe that the government is not opposed to the idea and rather, may be inclined to it. The government is prepared to make a beginning. There is a realisation that if these things are not done today, market forces would compel them to happen, which will be more painful. The current investor would lose value if things are not done in a timely manner.

If the government still wants a foot in the door through a 26 per cent or 40 per cent stake, will an investor be willing to come on board? That is still something that needs to be tested. And if the government is moving away from that scenario, how will it impact the liability franchise of those two entities? These are two unknowns. That is the reason why it is important to pick up a couple of cases and observe the journey.

Kumar: If you are asking me if the government has the intent to give up ownership, I think we should not doubt that. Air India is an example. In the (previous) Budget itself the government has made it clear where they want to be and where they do not want to be. If public sector banks have lost market share and it has come down to 60 per cent and if RBI allows more banks, more fintechs, more NBFCs, then the share of public sector banks will go down gradually. Whatever way you do it, the role assigned to public sector banks will continue to lose its importance.

The execution plan and the intent of the government are two separate things. Currently, the intent as I read it, is a willingness to give up. We should not get into the area of a road map. The relevance of public sector banks has come down and will continue to come down. You can continue to hold these banks under government ownership with a continual decline in market share. Or you can accelerate the process by giving up ownership. We are looking at a 10- or 12-year timeframe for the government’s exit from the banking system.

Is it time to allow corporate houses to enter banking?

Kumar: It will be difficult to regulate banks owned by corporates, and to distinguish between a good corporate and a bad corporate. Whom you will allow and whom will you disallow, and on what basis? From a regulatory perspective it can be a nightmare. RBI wanted sweeping powers to examine all their businesses. But the key question is that if you have to privatise, we need capital.

Who has the capital? Today, finding capital may not be difficult, but it will be a gradual process. The overall market capitalisation of public sector banks other than State Bank of India is not a very huge number. At the same time, this aspect of who will be the investors will be an issue. But that does not mean that we allow corporates to own banks.

Sinha: Lending to a corporate is not really the issue. It is the treasury operations that we have to be scared about with corporates. The question that is perplexing is this: if you allow a corporate to start an NBFC based on wholesale borrowing, then to believe that the corporate — if it was borrowing from depositors — would find it easier to default on depositors than on wholesale, I don’t understand that logic. You have to be consistent. Either you don’t allow corporates as NBFCs, or if you do, what is the risk that we are facing? Are they going to default on depositors? Or, are they going to do connected lending? Connected lending has also become less attractive because most people are going in for retail.

Krishnan: You require a large amount of capital but you already have a negative predisposition towards foreign capital and private equity. So, anybody with capital, who is likely to be seriously interested, is getting ruled out. Corporates are the other actors here who have large capital and who have been permitted to operate in the NBFC space. But, in a weak governance environment, the risks of allowing corporates entry in banking far outweigh the gains.

In the longer term, the aim should be to move towards a much less bank-centric financial system, with greater development of bond markets and  a much stronger focus on banking regulation.

Mundra: Create a narrow entry corridor and allow widely-held NBFCs within corporate groups to bid for it on equal terms. If they are successful, allow them to own the bank, but be a very suspicious regulator, especially in the initial few years.