Privatising India’s banks

The case for privatising the public sector banks is ultimately a case for economic development

Privatising India’s banks
The subsequent record has been mixed, at best, and economic reform has included gradually making room for private sector banks, while trying to strengthen public sector banks through structural reforms.

In 1969, India’s government nationalised the country’s banking industry. The goal was to make financial services more inclusive, and to spur economic development by directing the financial sector. This was in keeping with the post-independence strategy of occupying the “commanding heights” of the economy, but that approach was already showing signs of dysfunction by that time. The subsequent record has been mixed, at best, and economic reform has included gradually making room for private sector banks, while trying to strengthen public sector banks through structural reforms.

In an analysis that has already received considerable attention, prominent economists Poonam Gupta and Arvind Panagariya (GP) make a careful and convincing case for a big push to privatize India’s public sector banks. Currently, there are 12 of these, but the State Bank of India (SBI) stands out in terms of its size, importance and operational quality. So, GP suggest that SBI remain in the public sector, but argue forcefully that the remaining 11 banks be privatised completely.

The case for privatisation is based on the relative record of public sector and private sector banks over recent decades. While there has been considerable variation in the quality of performance within each category, on average, private sector banks perform much better than their public sector counterparts. Greater efficiency through privatisation can improve the allocation of financial resources within the economy, promote growth in the financial sector, and support higher overall growth of the economy.

GP outline a course of action that involves starting with two strong public sector banks (already something suggested by NITI Aayog) as a model, with the rest to follow. Privatisation would involve complete government divestment, to avoid any shadow of discretionary interference after privatisation. This makes sense if the benefits of privatisation are going to come from independent management and operational efficiency. This rationale also means that merging public sector banks is not a productive policy pathway. GP are relatively agnostic on the exact process, including the possibility of dispersed ownership as well as large strategic buyers. In particular, they argue that non-financial corporates should be allowed to buy banks, with the issue of controlling crony lending being dealt with through appropriate regulation and enforcement. They note that technological innovation is already opening up banking and bank-like services to a range of non-financial companies, including various tech firms.

Bank privatisation will not be easy, but the timing seems to be right. India’s economy definitely needs a more efficient financial sector if it is to grow at rates that will generate enough good jobs for its population. There are strong political obstacles, because of the large number of people employed in public sector banks. Bank unions have already expressed their opposition, and the government has already postponed parliamentary consideration of the legislative changes that would be needed to allow privatisation to begin. It may seem easier to expand the banking sector by issuing new licences for private sector banks. But this would prolong the pain and increase the costs of having an inefficient banking sector.

While the political issues associated with privatisation are digested, there is clearly a need for a strategic vision and analysis of what India’s financial sector might look like a decade from now. This includes thinking about the impacts of technology, the role of non-bank finance companies, the competitive structure of the industry, scale and other considerations for efficiency, and—above all—a new regulatory architecture. Regulations can be designed to manage risk, as well as to promote efficiency and inclusion. In some cases, the regulatory framework is adequate on paper, but the capabilities for monitoring and enforcement are far too limited. RBI, currently beset with short term challenges of dealing with inflation and exchange rate management, ought to be investing heavily in upgrading its capabilities in all aspects of its role as a financial regulator.

India needs a much better-quality financial sector. Tech innovation opens up new possibilities for efficiency and inclusion. But finance involves a unique set of risks and challenges. Financial sector problems can spread like wildfire within the sector and bring down the entire economy. But underlying the GP proposals is a sense of confidence that India has the knowledge, experience and ability to dramatically restructure its banking sector. There is a clear technical case for pursuing privatisation, but the public sector has to step up in managing the political economy of the change, as well as in its post-restructuring regulatory responsibilities.

The case for privatising India’s public sector banks is ultimately a case for economic development. When the government sets goals of expanding the country’s manufacturing sector, these objectives will never be met without a better functioning banking sector. Indeed, privatising public sector banks can only be one component of a strategy of financial sector reform and growth, if manufacturing—along with the rest of the economy—is going to be able to thrive. Articulating that connection will be part of the political challenge of this reform.

The author is Professor of economics, University of California, Santa Cruz

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