Privatization of Banks: Benefits and Concerns – Explained, pointwise

Introduction

A report by National Council of Applied Economic Research (NCAER) has recommended that the Union Government should privatize all Public Sector Banks (PSBs), except the State Bank of India (SBI). The Report further states that the Government ownership hinders the ability of the RBI to regulate the sector. The recommendation of complete privatization of banks has led to sharp reactions from the critics. According to them complete exit of the Government will give rise to systemic risks in the financial sector. The Union Government is aggressively pursuing the exercise of disinvestment. For the ongoing fiscal year FY22, the Government has set a disinvestment target of Rs 1.75 lakh crore. The plan includes privatization of two public sector banks, public listing of the Life Insurance Corporation of India, Shipping Corporation of India, and many other PSUs.

About the Ownership Trend in Banking Sector in India

After the formation of Reserve Bank of India in 1935, to the period till Independence (1947), there were 900 bank failures in India. From 1947 to 1969, 665 banks failed. The depositors of all these banks lost their deposited money. The Government nationalized 14 major banks in 1969. After this 36 banks failed but these were rescued by merging them with other government banks. This included even bigger banks like Global Trust Bank. 6 more banks were nationalized in 1980.

However, since the liberalization of the economy in 1991, the discourse on bank onwership has changed significantly. Guidelines for setting up private banks were established in 1993 and the ICICI Bank was set up in 1994. Since then the Private Banks have expanded their footprint.

Simultaneously, the approach of the Government has been to reduce its presence in the Banking Sector and reduce the number of Public Sector Banks. In 2019, after a massive consolidation exercise, the number of PSBs reduced from 28 to 12.

During the Union Budget 2020-21 presentation, the Government announced a new policy for strategic disinvestment of public sector enterprises. This policy provides a clear roadmap for disinvestment in all non-strategic and strategic sectors. The Banking Sector falls under the strategic sector. The Government  announced privatisation of two PSBs as a part of its disinvestment plan. 

What have been the benefits of nationalization of banks?

The nationalization of private banks in 1969 resulted in the penetration of banking sector in the rural areas of India. Private Banks were reluctant to open branches in rural India due to low profitability. However, nationalized banks followed the mandate of the Government and helped in financial inclusion.

The Share of Bank Branches in rural areas increased from <18% in 1969 to ~60% by 1990. This shift happened due to several initiatives by Public Sector Banks like the Lead Bank Scheme launched by the RBI in 1969.

Only after nationalization of banks could small borrowers get credit and there was a shift from class banking to mass banking.

Banks were used to bring about a revolution in agriculture and to carry out activities related to it.

The Sectoral allocation of Bank Credit underwent a change after nationalization of banks. The Share of Agriculture improved from 2.2% in 1968 to 16% in 1989. The share of credit to Industry decreased from 67.5% in 1968 to 37.5% in 1989. This shift happened due to expansion of rural branches and Priority Sector Lending norms.

The proliferation of branches created job opportunities for large section of educated youth. It also benefitted local rural economies.

There was an increased public confidence in the banking system. The growth rate of saving bank deposits witnessed a rapid rise post 1969.

42 crore ordinary people have opened bank accounts as a result of the immense contribution of state-owned banks in opening Jan Dhan Yojana accounts.

What are the arguments in favour of Privatization of Banks (NCAER Report)?

First, private banks have emerged as a credible alternative to PSBs with substantial market share. PSBs have lost ground to private banks, both in terms of deposits and advances of loans. Since 2014-15, almost the entire growth of the banking sector is attributable to the private banks and the SBI.

Second, Government ownership hinders the ability of the Reserve Bank of India (RBI) to regulate the sector.

At present PSBs are under the dual control of the RBI and the Department of Financial Services of the Ministry of Finance. The RBI handles the governance side of the PSBs under the RBI Act, 1934. The Department of Financial Services maintains the regulation of PSBs under the Banking Regulation Act, 1949. Thus, RBI does not have the powers to revoke a banking license, shut down a bank, or penalize the board of directors for their faults. Privatization will provide the powers to RBI to control them effectively.

Third, barring SBI, most other PSBs have lagged behind private banks in all the major indicators of performance during the last decade. These PSBs have attained lower returns on assets and equity than their private sector counterparts. The non-performing assets (NPA) of PSBs remain elevated as compared to private banks even as the government infused US$ 65.67 billion into PSBs between 2010-11 and 2020-21 to help them tide over the bad loan crisis.

The market valuation of PSBs, excluding SBI, remains ‘hugely’ below the funds infused in such banks as of May 31, 2022.

Fourth, the under-performance of PSBs has persisted despite a number of policy initiatives aimed at bolstering their performance during this period. These initiatives include: (a) Recapitalisation of PSUs; (b) Constitution of the Bank Board Bureau to streamline and professionalize hiring and governance practices; (c) Prompt corrective action plans; (d) Consolidation through mergers.

Fifth, the steady erosion in the relative market value of PSBs is indicative of a lack of trust among private investors in the ability of PSBs to meaningfully improve their performance.

Sixth, the current fiscal position of the Union Government is not strong enough to provide huge sums for recapitalization and keep on sustaining sick PSBs.

Seventh, the privatization of banks will have a positive impact on the economy by bringing stability at the macroeconomic level. Privatization of a few loss-making PSBs will ensure that market discipline forces them to rectify their strategy, and this will have a ripple effect on other PSBs. 

The pandemic has led to the severe decline in the economic curve of the nation and has made a negative impact on banks as a whole, which makes it imperative to take all possible steps to revive the banking sector.

What are the challenges in Privatization of Banks?

First, as per the stated policy of the Reserve Bank of India, banks cannot be run by industrial houses.  However, excluding the industrial houses, there are no entities that have the required financial capability to take over any of the government banks.

Second, private banks have a long history of failures, as noted above (>1500 banks failed between 1935-1969). Recently, the RBI had to come to the rescue of Lakshmi Vilas Bank and YES Bank by pumping of capital by other entities to save these banks. Bank failures and lack of Government intervention will increase the risk in the banking system.

Third, Banks owned by the sovereign government provide more comfort level to depositors. Expansion of private sector in banking will reduce consumer confidence in the sector.

Fourth, Private banks operate with the sole aim of adding shareholder value. In contrast, the government banks also try to serve society and ensure implementation of all government programmes for the social sector. Privatization might have a negative impact on financial inclusion, agriculture credit etc.

Fifth, bank workers are opposed to privatization. as they fear loss of jobs.

What should be the approach going ahead?

Recommendations of the NCAER report

The two banks chosen for privatization must be the ones with the highest returns on assets and equity, and the lowest NPAs in the last five years. It has recommended Indian Bank and Bank of Baroda as the two top choices for privatization. This would set an example for the success of future privatizations.

It also makes a case for corporate ownership in banks with due diligence as there is “scarcity” of potential large-scale investors in banks. The government must allow foreign investors, including foreign banks and domestic investors, as well as corporate houses to enter the auctions with due diligence

Any potential risk may be minimized by letting a consortium of corporations enter the bidding with the stake of any single corporation capped.

Recommendations of PJ Nayak Committee

Though the Government approved the Bank Board Bureau, the government has to provide enough support for proper functioning. The government can split the Chairman and Managing Director roles. Further, they should be allowed a fixed tenure of 3-5 years.

Recommendations of Narashimham committee

The Government can explore the concept of Narrow Banking. Under this weak PSBs will be allowed to place their funds only in the short term and risk-free assets. This will improve the performance of PSBs.

Other Measures

The Government must create strong recovery laws and take criminal action against wilful defaulters. The challenges in the Insolvency and Bankruptcy Code (IBC) must be addressed. This will provide a faster resolution process. In the meantime, the Government can explore alternate steps such as the concept of Bad Banks.

Conclusion

Privatizing all the PSBs and complete exit of the Government might have significant negative consequences. The Government must find ways to strengthen the governance of banking system and ensure safety of depositors’ money. Complete exit may not be an option, for now.

Source: Business Standard, The Hindu BusinessLine, Outlook, CNBC