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Privatization of India’s Public Sector Banks

PNB fraud reopens the debate on privatization
The massive Rs.13,000 crore scam involving fraudulent letters of undertaking (LOUs) issued by Punjab National Bank (PNB), India’s second-largest public sector bank (PSB), has reopened the debate on privatizing India’s state-owned banks. The discovery of the fraud has caused further turmoil in the banking system which, over the last few years, has been under tremendous pressure from substantial non-performing assets (NPAs). In January 2018, an ASSOCHAM-CRISIL study estimated that the Indian banking sector would have gross NPAs amounting to an astounding Rs. 9.5 lakh crores by March 2018, up from Rs. 8 lakh crores a year ago.
Experts are divided in their opinion regarding the privatization of Indian PSBs. Rajnish Kumar, chairman of State Bank of India (SBI), India’s largest bank, mentioned that the current timing was not right for privatization of PSBs. He explained that banks needed to be strengthened and made financially attractive before divesting them, a process which he expected would take at least two years. Although Kumar was not against privatization of some banks, he indicated that the banking system’s social initiatives would suffer if many state-owned banks were privatized since SBI could not singlehandedly meet the goals of social inclusiveness set by the government.
Indian-American economist Arvind Panagriya, who served as vice chairman of the NITI Aayog between January 2015 and August 2017, stated that although a series of reforms initiated by the Reserve Bank of India (RBI) and the government in 2016 and 2017 had improved the banking system’s health, they were not sufficient. Additional structural reforms were needed in the longer term to ensure a comprehensive transformation of the banking sector. According to Panagriya, one of the reforms which would have to be prioritized by the next government was privatization of all PSBs except SBI.


Not privatizing banks: The most significant missed opportunity
Ruchir Sharma, head of emerging markets and chief global strategist at Morgan Stanley Investment Management, recently highlighted that the failure to reform India’s banking system was the current government’s biggest shortcoming. He concurred with the view that this was the most significant missed opportunity by the government. As per Sharma, while PSBs were a requirement in every country in order to meet social objectives, the situation was particularly skewed in India where nearly two-thirds of all assets were concentrated in state-owned banks. In emerging economies, this figure averaged one-third.
A strong banking system is the backbone of a country’s economic framework; failing to strengthen it will not allow the country to realize its full economic potential. This situation is currently playing out in India. According to Sharma, an excessive regulatory environment will be the leading risk factor for India in 2018. Many PSBs are facing severe lending restrictions, with the result that credit is flowing to only reputable organizations. This risk aversion is impacting small and medium enterprises the most, particularly since the outcome associated with non-performing loans is being increasingly perceived as a criminal offence.
In October 2017, the government announced a Rs. 2.11 lakh crore recapitalization plan for PSBs to help them clean up their balance sheets and meet capital adequacy requirements. These measures would increase lending activity and spur private investment, thereby boosting India’s overall economic growth. While the International Monetary Fund (IMF) welcomed the recapitalization and other banking sector reforms, it emphasized that recapitalization should be part of a broader financial restructuring to address NPAs, improve governance in PSBs, limit the public sector’s role in financial markets, and augment bank lending capacity.


Privatization not a substitute for banking sector reforms
It is largely accepted that government ownership of businesses leads to sub-optimal economic consequences. The RBI has frequently attributed management lapses in PSBs to government ownership. However, this does not absolve the central bank of its own shortcomings, such as its failure to enforce capital adequacy norms among PSBs, ensure that the banks have implemented sufficient safeguards to prevent frauds, and transparency in their financial statement disclosures.
While the RBI does not have the same powers over PSBs as private sector banks, it does have the right to appoint a director on the board of a PSB. Such a director needs to necessarily have expertise and experience in regulating and supervising banks, a capability which vests only in the RBI. This power can be used by the central bank to constantly supervise PSBs. Experts believe that privatizing state-owned banks with existing levels and quality of regulatory capacity/oversight may prevent one category of banking management lapses (including fraud and inadequate system controls) while giving rise to other lapses (understating NPAs or mis-selling financial products).
Economists are of the view that although privatization is capable of solving many economic issues, freeing up fiscal resources and reducing corruption, it is not a substitute for regulatory lapses. Privatizing banks as a knee-jerk reaction to the current banking system crisis without solving fundamental regulatory problems will not prevent such crises from occurring at regular intervals. This will defeat the purpose of privatization.

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