When India survived the global financial crisis relatively unscathed, several prominent public figures claimed that the country?s public sector banks had been pillars of stability and resilience, contributing to the economy?s strong performance under stress. Indeed, during the crisis, households and firms shifted money from private to public banks, and the latter outperformed the former through those tough times. But what really happened? At the recently held India Policy Forum, Viral Acharya of New York University provided a comprehensive and provocative empirical analysis. No such analysis is perfect, but there is great merit in actually digging into the data, rather than jumping to conclusions and shaping policy without adequate investigation.
Acharya shows that private sector banks that were more vulnerable to crisis (he uses a specific measure of systemic risk) indeed suffered greater deposit contractions during the crisis, as would be expected. But this relationship did not hold at all for public sector banks?indeed, it might have been the opposite. He conjectures that the nature of government guarantees could explain this unusual outcome, since public sector banks are more effectively or obviously protected from all kinds of risk, even beyond basic deposit insurance protection for individuals.
There is also a provocative comparison with the US, where government guarantees for Fannie Mae and Freddie Mac in the mortgage market allowed those two institutions to crowd out the private sector, and fall prey to political compulsions for expanding access to home ownership. This, in turn, could have contributed to lax mortgage lending standards, deteriorating to fraud in many cases. This comparison is reminiscent of older arguments that public sector banks in India have been subject to political compulsions in their lending decisions, leading to poor financial performance and greater systemic risk.
One can argue with Acharya?s analysis, and certainly there is more work to be done. Bank nationalisation has been found by some researchers to have contributed to expansion of bank branches (and hence, presumably, financial inclusion). While this is an argument based on the benefits of financial development, rather than insulation against downside risk, it could be taken as justifying the cost of government guarantees. It is also true that the government effectively does guarantee private sector banks as well?none have ever been allowed to fail. But that could be taken to support Acharya?s conclusion that what matters is strong and effective regulation, rather than ownership. Indeed, from the perspective of economic theory, there is a case for financial sector regulation, but not for public sector ownership of financial institutions.
The lack of trust in private sector banks displayed by Indian consumers and firms in extremis could also be an argument for public sector ownership, if it is based on inferences by customers that the private sector is more prone to sharp practice or deceit (as opposed to the perceived ?laziness? of the public sector). But here, too, the correct conclusion could be that better consumer protection is required, rather than government ownership. The government?s job is to make sure that public goods, like information, are provided, and externalities caused by information asymmetries are dealt with, and that does not require the government itself to run the banks. Furthermore, if trust comes from experience, and good experiences come from competition, stunting competition by chaining private sector banks or artificially propping up public sector banks creates a self-fulfilling prophecy of doom.
The political economy aspects of bank ownership are also interesting. It can be argued that public sector banks can be regulated more effectively than those in the private sector, because they are more subject to informal moral suasion, for example. But the obverse is that they can be more easily corrupted. Indeed, in the US case, not only were the government guaranteed mortgage institutions poorly regulated, so were the private sector investment banks. Again, it was the quality of regulation and regulatory enforcement that mattered, rather than public or private ownership.
So, did nationalised banks save India from the financial crisis? Probably not. If anything, strong and effective regulation, irrespective of ownership, was what mattered. This does not mean that the regulatory system cannot be improved?indeed, there is much more analysis required for improving the design of financial sector regulation. Should India?s public sector banks be privatised? One cannot jump to that conclusion either. However, Acharya?s empirical work indicates that public sector ownership has not been a panacea for resistance to financial crises.
One way to improve the status quo, in addition to improving the design of the regulatory system, is to increase the market discipline for public sector banks, by pushing for them to be listed on the stock exchange, and gradually increasing the percentage of shareholding by the public (the real public, rather than the government). And loosening up restrictions on private sector bank expansion would also provide increased competition for public sector banks. Faster financial development and greater financial inclusion can be achieved without increasing systemic risk.
The author is professor of economics, University of California, Santa Cruz