What ails public sector banks? Ownership would be a good place to start

The public sector banking problems are not confined just to NPAs and capital adequacy but the entire approach is flawed

The government has decided to merge 10 very broke public sector banks into four. This will happen on April 1.  This way, even if there are other problems, their capital requirements will be substantially met.

But that’s only one aspect of the problem and a fairly small one of the overall Indian banking scene. Without going into the question of whether India did the right thing in accepting Basel III norms, there is another very important question that is never discussed. This is the risk part of banking. All these years we have been obsessed with size and neglected the systemic risk that very large banks pose. In the US, for example, they don’t concentrate risk in a few large banks. They prefer lots of small banks.

Not just that. It turns out that a large bank in the US is not defined by the size of its business but by the number of branches. A bank with more than 500 branches is called a large bank. They are regulated accordingly.

Nor is bank failure regarded as a major calamity. It’s seen as the just punishment for poor risk assessment capability. So banks do fail every year. In the Savings and Loans disaster alone over a thousand had collapsed. But simultaneously new banks keep coming up. They don’t merge bad banks with good ones.

This has a consequence for market share also. The domestic share of even the largest bank in USA is nowhere near that of several of Indian PSBs. In other words risk is diffused.

Illustration by Ajay Mohanty

One other feature is that commercial banks don’t usually get into long term finance. That’s left to the bond market which we are trying to develop but with little success. India used to have development finance institutions but they were wound up in the late 1990s. Now the commercial banks lend to long gestation, risky projects without quite having the skills to assess risk accurately.

And, if one may make so bold, it allows massive corruption because (a) the banks are state owned and controlled by politicians and (b) the sums involved are immense. Risk is thus political as well, which is never acknowledged.

There’s also the question of how to measure the size of the balance sheet. The practice of measuring it in dollars can results in avoidable peculiarities because of exchange rate issues. What happens to the size when the rupee depreciates? Or appreciates?

Practically all these problems flow from one single decision of the government in 1969: nationalisation. The fact that ownership had changed also meant that the way of running things would change. And they did.

Nowhere was this more apparent than in the recruitment and management of employees. Not to put too fine a point on it, bankers have become bureaucrats more attuned to assessing organisational and career progression risk rather than business risk. Those that didn’t conform fell by the wayside, rarely making it beyond middle management.

So, in a nutshell, the public sector banking problems are not confined just to NPAs and capital adequacy. The entire approach is flawed. And this is because of ownership. Unless this changes we will only be concentrating risk by mergers which though necessary are not sufficient.

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