Bank deposits have allowed India’s democracy to survive. Public sector banks (PSBs) gave the Indian depositor confidence that their money was safe, at the same time, it made it easier for the government to access these deposits and direct them. Any discussion on PSB reform needs to recognise this important externality. When banks were nationalised in 1969, India was seen as a basket case economically. India had pervasive poverty, full suffrage, the Hindu growth rate (3.5%), high inflation (double-digit for much of the 1970s) and no access to external commercial capital. Globally, we did not matter other than as aid recipients! Electoral victory required either an event—Bangladesh war, Emergency, an assassination even—or targeted sops to appease the voter. Further elections (national, state, municipal) were always on and there was no organised form of political-funding. Tax policy was poor, with very high tax rates on a small base, leading to endemic tax evasion till the reforms of 1997. So, the only real options other than aid, were printing money, or tapping into bank deposits.
This was done in a big way. In the mid-1970s, the statutory liquidity ratio and cash reserve ratio accounted for over 50% of net demand and time-liabilities and internal borrowing were an important component of the Plan outlays. Priority-sector-lending, at 40%, was directed at important political constituencies like farmers, small- and medium-enterprises and the poor. The remaining credit was rationed through the credit authorisation scheme run by RBI. Not only that, at times of electoral necessity, farmers were given loans at organised melas and loan waivers were endemic. What was not explicitly mentioned was that bank deposits, routed as loans to industry, also funded political parties. The needs for election funding were large and much of the corporate wealth that was created was on the back of bank borrowing.
Government ownership avoided any bank-runs. The returns offered to depositors were poor and did not match inflation pushing them to prefer gold and real estate for capital protection. Luckily, it was clear to successive governments that they could pillage these banks only up to the point that they did not collapse. After periods of heavy pillage, there would be short periods of restraint. The government would then recapitalise the PSBs and the situation would stabilise.
From the mid-1990s, when the reform process started in India, many good things happened together. By about 1995, the economy started to pick up and higher growth expanded the tax base. At the same time, global pressure, combined with skilled reformers, pushed PSB reform. Between 1995 and 2002, five major steps were taken: first, a serious focus on managing NPAs; second, private banks were licensed to encourage competition; third, banks were asked to list and come under market scrutiny; fourth, PSBs were forced to adopt core banking solutions (CBS), providing real time data; and fifth, they were encouraged to use outside help to restructure. By 2005, India’s corporate sector also started doing well and debt-equity ratios came down from 3 to 0.8. During this period, the public sector banking system was financially cleaned up. As a result, by 2008, the PSBs had increased return-on-assets (RoA) from 0.4% in 2001 to 1%, and NPAs were reduced from 12.2% to 2.2%. Over-staffing changed to under-staffing. In 2000, the PSBs had total assets of R9,23,631 crore with 8,74,116 employees. By 2013, they had total assets of R69,61,967 crore with 8,11,333 employees.
The strength of PSBs in 2008 led to the familiar pillage pattern. The eleventh Five-Year Plan targeted a $500 billion infrastructure spend, with national GDP at $1 trillion, it was abundantly clear to the government that it did not have the resources to build India’s entire infrastructure. It required active private sector participation, to the extent of 37%, via public private partnerships (PPP). So, in effect, private sector was asked to participate in the highest risk assets with a “maybe” return offer. This time round, the private sector used PSB balance sheets to fund the infrastructure investments, sometimes with gold-plated projects. PSBs lent to infrastructure with active government exhortation. However, the regulatory mechanisms to manage PPP were evolving and not tested. Further, the policy environment on account of belief, political considerations and plain old rent-seeking became unstable. As a result, between 2007 and 2013, over 50% of the infrastructure or capital investment projects got stuck due to the lack of environment, mining or land clearances to the tune of $106 billion. Most of these projects today require fresh financial closure. PSB balance sheets suffered and today, their RoA is down to 0.6%, and their NPAs and restructured loan portfolios are 12%.
This is the context. Is PSB reform still possible? Surprisingly, my answer is a strong yes, but not in the old way anymore. We need to go beyond assertions of self-restraint and will power as they have a short shelf-life. I believe
PSBs currently face three specific issues—they need recapitalisation (to deal with NPAs, Basel requirements and for growth of their balance sheet), they need governance autonomy (from Parliament—for strategic moves like acquisition, the vigilance apparatus, and the ministry of corporate affairs for CEO and Board appointments), and they need HR autonomy (in recruitment and compensation).
Within the construct of India’s political economy institutional measures are required to confirm autonomy and independence. At a minimum, the government should create bank-level holding companies so that they are not directly controlled and can enjoy autonomy akin to, say, the UTI mutual fund or some of the PSB subsidiaries. This provides them full HR autonomy. Procedures can be created for acceptable CEO and Board appointments (A nomination committee of the board with a government director and three large investor nominees—with the government proposing names that the investor nominees consider). But in the long-term, government control will be truly effective, and PSB price to book ratios comparable to private banks, if the government stake in the holding company comes down below 51%. The best examples come from how the private promoters control their institutions. Kotak Bank is not 51%-owned by Uday Kotak but controlled by him. Similarly, the government should be the single-largest share owner with more than 26% stake but below 51%. No other investor is allowed more than 5% anyway. Axis Bank was a good example when SUUTI and LIC jointly owned more than 26 %. This does not reduce the government control (or change the public character) of PSBs; it just makes it more effective and sustainable. It creates a welcome tension between the market and the promoter, like it does for any private promoter. It allows mandated government interventions but makes discretionary interference much harder. This is the solution that our PSBs need. Doing this will transform our banking sector—it will have a mix of robust PSBs, strong private banks, foreign banks and newly-licensed banks spurring innovation. A model for the world!
The author is chairman (Asia Pacific), The Boston Consulting Group