The story of public sector banks (PSBs) is also something similar. There is a scarcity of bank capital which got created because of the inefficiency and maladministration of the government, either explicitly or implicitly. The government doesnt allocate as much capital as is needed. It doles out a few thousand crore each year which seems large in absolute terms, but is a pittance in the banking world. It doles so little because, allocating money to a Rozgar Yojana gets the electronic voting machine ringing, but earmarking badly-needed resources for the good health of the PSBs hardly humours the electorate. Chronic non-allocation of capital due to high-degree myopia and short-termism creates scarcity. When the problem become endemic, the government comes as a knight in shining armour and rescues the PSBs.
The story of Air India is analogous and helps in understanding the current problem of the PSBs. Air India wouldnt have been such an inferior airline but for the government. After continued negligence, maladministration and bungling, the government finally comes as the rescuing knight. It comes across as the all-compassionate benevolent entity in times of trouble and therefore must be good for the airline and the economy. We forget that Air India would not have been in trouble in the first place if the government hadnt made such a mess of running it.
It does sound quite panicky, but a not-so-well-known reality is that PSBs in India are experiencing significant distress and suffer from thin bank capital. Exacerbating the problem is low investor confidence in PSBs, highlighted by the equity issue in January 2014 of State Bank of Indiathe bellwether for PSBs. SBI sought to raise R9,600 crore via a share sale to institutional investors in the domestic market. However, it could raise only 80% of that amount, R8,032 crore. Even that 80% transpired only because 41.3% of the issue was bought by the state-owned Life Insurance Corporation of India. Foreign investors largely stayed away from the offering. If investor confidence in the State Bank of India is feeble, then their confidence in other PSBs can only be fragile, which raises significant concerns about PSBs ability to raise capital from the markets.
It is time we laid that old chestnut PSBs are safe because they are owned by the government to rest. After all, the recent financial crisis in the Eurozone has highlighted the slack-jawed silliness of state-owned banks being safe. The reality is, PSBs are currently thinly capitalised, despite inadequate provisioning for stressed assets. They have low and declining return-on-assets, low and declining net interest margin, low productivity which is reflected in the significantly lower market-to-book ratio, and lower fee income as proportion of total income. Taken together, it is hard to escape the conclusion that PSBs remain a drain on taxpayers resources apart from being highly susceptible to future shocksthe banking equivalent of Air India.
As we speak, the government would have to invest about R62,000 crore, or about 12% of current fiscal deficit, to keep PSBs above mandatory Tier-I CAR requirements. Over the next 5 years, government would need to invest about R1,80,000-2,50,000 crore to keep PSBs above mandatory Tier-I CAR requirements. Thats how severe under-capitalisation of PSBs is. Allocating a few thousand crore, as in previous budgets, is akin to rearranging the deck chairs on the Titanic. If remedial action is not taken soon enough, government investment in PSBs would be exorbitantly costly to usthe taxpayers. After Air India, the dysfunctional government ownership of PSBs is the latest, saddest and costliest example of governments ineptitude and malfeasance.
The government now has two options. Either, it can privatise the PSBs and allow future solvency of these banks to be subject to market competition, including through mergers. Or, it can design a radically new governance structure for PSBs with minimum intervention from the government. This would better ensure their ability to compete successfully, in order that repeated claims for capital support from the government, unconnected with market returns, are avoided. Either way, the government has to let go its choke-hold on the PSBs.
Henry Ford said, It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning. You could paraphrase that to the context of PSBs in India today. It is well enough that the average depositor does not understand the extent of under-capitalisation of PSBs, for if he did, there would be a bank-run before tomorrow morning.
The author, formerly with JPMorganChases Global Capital Markets, trains finance professionals on derivatives and risk management