Narrow, not niche

Many public sector banks should be turned into safe banks

Union Finance Minister Arun Jaitley, senior bureaucrats and leading public sector bankers met in Gurugram for a “PSB Manthan” over the weekend. The event saw the government and bankers brainstorm on a variety of issues related to state-owned banks. Some of the key issues were predictable: Resolution of bad loans, improving the credit offtake and focusing on consolidation in the sector. Mr Jaitely reminded the bankers present that the Rs 2.11 lakh crore recapitalisation announced by the government recently would by itself not be enough for state-owned banks to credibly support economic growth. 

Most struggling public sector banks (PSBs), which anyway have poor governance structures, have lent to a host of sectors without paying due attention to strengthening their risk management systems. Over time, their bad debts have stacked up and merely throwing money at them now through recapitalisation bonds will not help. Nor will consolidation work, as weak state-owned banks are likely to bring down the performance of the stronger ones. A related suggestion is that the smaller and weaker banks should, instead of copying their bigger rivals, focus on niche banking. The idea being that since smaller banks do not have the wherewithal to capably address the needs of different types of businesses and sectors, they are better off focusing on specific segments. But “niche” or “differentiated” banking is not a new idea and the Reserve Bank of India (RBI) has, over the last few years, considerably altered the banking architecture to allow different types of banks, including payments banks, which have a focused area of business. 

It is debatable how many of the smaller and weaker PSBs are capable of turning into niche banks catering to sectors such as small and medium enterprises or agriculture. Such banks need expertise to assess risks and rewards in the sectors concerned, and in the absence of such wherewithal trying to become niche banks could result in a deterioration in their financial health. Given the political difficulty in closing them down or reducing the government’s stake in them to a minority holding, the only viable solution is to turn weak PSBs into “narrow” banks that invest in safe and liquid assets such as gilts backed fully by demand liabilities. “Narrow” banks are not allowed to lend to big borrowers or to expand staff or branches, and the focus is on the recovery of as many bad loans as possible till they reach a point where they begin to look viable.

Former RBI deputy governor S S Tarapore had suggested that the deposit-taking and lending functions of “narrow” banks be separated. In ensuring that all incremental deposits flow into government securities, the lender’s loan book growth declines and a stronger buffer is created due to the increased investment in gilts. Narrow banking will also reduce the need for regulatory monitoring. Of course, it cannot be a one-size-fits-all strategy and it must be applied selectively and carefully to banks displaying persistent weakness. That could be a good starting point for bringing these banks to a position where they can be merged with their larger competitors.