Options to de-stress public sector banks

The degrees of freedom available for govt's arbitrary decisions are circumscribed by financial market dynamics

Several options are being considered to address the NPA problem of public sector banks, sometimes on a standalone basis and, sometimes in conjunction with other measures to solve the underlying issues that result in demand for capital infusion.
 
Consolidation of banks in public sector is an option, but that by itself does not increase capital or address weaknesses common to all banks being considered for consolidation. If the problem is governance, how does consolidation help? A bad loans bank was suggested but recourse was taken to this method in other countries to meet exogenous shock to banking system but not due to endogenous stress.
 
A combination of further regulatory forbearance and removal of constraints such as SLR or CRR was proposed. But, the former only buys time — like changing the measure of sickness. The latter should be done in any case, but the scope is limited in the short-run due to government borrowing programme; the sterilisation of capital flows and the recent liquidity overhang due to demonetisation.
 

In brief, there seems to have been a consensus in favour of recapitalisation as the necessary first step while considering all other options to reduce chances of recurrence of such problems in banking system. The preferred option now seems to be a significant reliance on issue of bonds to fund the injection of equity — with more equity to weaker banks. Bond financing should normally imply increase in fiscal deficit, but it can be interpreted to define in a manner that it does not. Whatever manner it is defined, it adds to the fiscal burden in terms of payment of interest in future. This burden could potentially be compensated by returns on equity injected. Current approach appears to inject more capital to weaker banks since their needs are more.
 
The Fourteenth Finance Commission had something to say on this.
 
“In our view, there is scope and need to further lower the fiscal costs of re-capitalisation by restricting it to select and better performing public sector banks, instead of an across-the-board policy of covering all of them, in view of the competing demands on available budgetary resources. The non-performing public sector banks may be advised to manage their asset portfolio and growth in tune with the available capital. This will promote competitiveness amongst these banks and act as a hard budget constraint on them. This approach requires a view to be taken on, as well as an assessment of, the number of public sector banks that can cater to the desirable share of the public sector banking system in India, in order to serve the social objectives.”
 
The Fourteenth Finance Commission also recommended (Number 107), a broader view of the whole problem of keeping or putting tax-payers money in public sector financial entities.
 
“We recommend that a Financial Sector Public Enterprises Committee be appointed to examine and recommend parameters for appropriate future fiscal support to financial sector public enter rises, recognising the regulatory needs, the multiplicity of units in each activity and the performance and functioning of the DFIs.”
 
In brief, it is necessary to make explicit the stand of the government on these important recommendations.
 
In view of the large amounts of public money involved, the government may put in public domain action taken on Fourteenth Finance Commission’s recommendation for improving the financial system with economical use of tax payer’s money.
 
Why not privatise public sector banks?
 
To understand the scope and limits to Privatisation of public sector banks, we need to go back to the nationalisation of banks in 1969. The nationalisation of banks changed balances in a fundamental manner. Union government had till then no official functionaries in the states for initiating or implementing its programmes. The Union government acquired a country wide presence of its functionaries, albeit indirect. Second, the private sector had to depend on the Union government owned banks for funding of their activities since financial intermediation in formal sector was mostly confined to banks. Third, the Reserve Bank of India's command over monetary policy, especially transmission and regulation of bank was diluted. Fourth, large financial resources became available for the Government, which could be used without Parliamentary oversight. The banking system in India, thus, became a useful means to launch many of Prime Minister’s country-wide programmes, even though they were in the jurisdiction of states.
 
The reform of 1991 brought about another role for public sector banks. They became critical for public-private partnership, but they also became the bridge between politics and business. Just as there were debates in 1969 as to whether we should have social control or nationalise, we now have a debate between privatisation or recapitalisation, or recapitalisation followed by privatisation. Still, it will be political decision, but one with enormous economic consequences as at the time of nationalisation in 1969 and later in 1980.
 
The origin of public sector banking was political; it was through an ordinance; its evolution has been political and its future will, perhaps, be determined on political economy considerations. 2017 is vastly different from 1969. The balance between Union and states has been changing. The balance between state and market is different now. Private sector is more nimble than ever before. Private sector is used even for a sovereign function like issue of passports. People are demanding more choices than before. India is an integral and important component of global economy and, indeed, global finance. Finance is more complex now, and goes beyond banking.
 
The context of banking in India is also different now. We are already in a mix of public and private sector banks. We are in a world of public sector banks having a mix of public and private ownership. We are in a world where empirical evidence for comparing their performance is available — though subject to multiple interpretations. More important, we are in a new world where foreign investors have strong presence both in private sector banks and in public sector banks. So, for policy makers, the choice is more difficult and, processes more complex than in 1969. The degrees of freedom available for arbitrary decisions by government are circumscribed by dynamics of financial markets.
 
In brief, the future of public sector banks is unclear to them; and this itself undermines their efficiency, and also efficiency in the banking system as a whole.  (Excerpted from the K L N Prasad Memorial Lecture delivered by the former RBI governor in Hyderabad on February 1)