Big Bank Theory: PSU banks merger must be followed by good governance

Published: September 23, 2019 3:30:14 AM

The proposed merger of PSBs is a good starting point for reforming the Indian banking system, but it has to be followed by good governance

Governance of PSBs has been a major challenge from the time these banks were nationalised.Governance of PSBs has been a major challenge from the time these banks were nationalised.

By Himanshu Arora

The government has unveiled a mega plan to merge 10 public sector banks (PSBs) into four, thereby reducing the number of state-owned banks from 18 to 12.

Under the consolidation process, the Oriental Bank of Commerce and the United Bank of India will be merged in the Punjab National Bank; the Syndicate Bank with the Canara bank; the Andhra Bank and the Corporation Bank with the Union Bank of India; and the Allahabad Bank with the Indian Bank. The aim is to create next-generation financial institutions with stronger balance sheets and bigger lending appetite.

The proposal to merge poorly-managed banks with well-governed ones has been recommended by numerous committees since the 1990s. A committee under the chairmanship of M Narasimhan recommended the number of PSBs be reduced and 3-4 large banks should be developed as international banks. The report envisaged a three-tier system with 3-4 large banks at the top, 8-10 banks having nationwide presence catering to the needs of industrial and infrastructural sectors, and a large number of regional rural and local banks focusing on agriculture and rural sector.

Experts believe that reducing the number of state-owned banks will improve the collective performance of the banking system. It will bring economies of scale through optimal use of capital and resources, and ensure higher technical efficiency with higher profitability. The additional resources can be used in hiring domain experts and enhancing manpower, the absence of which is partly responsible for the NPA crisis. The logic being that bigger and well-managed banks are better equipped to respond to the lobg-term finance needs of industrial and infrastructure sectors. Further, PSBs—under stress due to NPAs—would find themselves adequately capitalised. This is expected to aid the banking sector in restart the lending exercise to the productive sectors.

The next logical step should be to find the right experts who can steer this consolidation—a move that requires a slew of reforms. Governance of PSBs has been a major challenge from the time these banks were nationalised. The Narasimhan committee recommended that banking boards be empowered and adopt a professional corporate strategy.

The problems of PSBs are structural. The merged banks may fail if governance structures are not reformed. This must be addressed. Accordingly, post-merger, the focus should be on effective governance reforms. The roadmap has been provided by the PJ Nayak committee—legal changes to incorporate banks under the Companies Act and the repeal of bank nationalisation Acts, dissolution of government ownership, and setting up of a Bank Investment Company (BIC). The BIC will act as a safety valve and an institutional firewall between the government and bank managements. The process of appointments to top management needs to be professionalised initially through an interim Banks Board Bureau (BBB), and latter through the BIC. BBB was set up, with a mandate to recommend candidates for top-post in state-banks; effectiveness is debatable.

Another issue with the proposed merger is the possible creation of what is known as systematically important institutions, which are too big to fail. Indeed, the State Bank of India was categorised by RBI as a systemically important bank whose failure could trigger a situation of bank runs. If such large banks were to fail due to governance issues, it could impact the economy and bring down the whole financial sector. A similar situation was witnessed during the Global Financial Crisis following the collapse of Lehman Brothers in 2008, and no country can therefore afford the failure of a big bank. Historical evidence suggests that if such a situation were to arise, the sovereign will be forced to rescue such large banks. The sovereign guarantees at many times encourage reckless behaviour by banks and creates the problem of moral hazard. Therefore, governance reforms along with effective regulation are essential to curb such moral hazard behaviour. It would require RBI to identify systemically important financial institutions from the merged banks and subject them to higher capital requirements.

The proposed merger is a good starting point for reforming the Indian banking system, but must be followed by genuine governance reforms.

The author works with the Economic Advisory Council to the PM, NITI Aayog. Views are personal

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