‘Stop Privatisation’: Why the Move to Privatise Public Sector Banks is Based on Flawed Assumptions

Unlike common assumptions, private banks do not inherently perform better than public sector banks. The reasons that are often cited for privatisation of public sector banks require deeper scrutiny.

On 15 and 16 March 2021, public sector bank employees under the banner of the “United Forum of Bank Unions,” an umbrella organisation of nine trade unions, went on a strike to protest against the government’s plan to privatise public sector banks. 

While Finance Minister Nirmala Sitharaman has assured that the salaries, pensions, etc, of bank employees would be taken care of even in the event of privatisation, the primary demand in the strike has been “stop privatisation,” going beyond the fear of the present fate of the striking employees to the consequences of such move for the entire nation. Warning that there would be more strikes in the future if the government went ahead with the proposed move, the unions have stated that privatisation was not in favour of the economy or the general public. 

In her budget speech for the Union Budget 2021–22, Sitharaman had announced that the government would privatise two more public sector banks (after IDBI Bank) going forward. Despite the unprecedented two-day nationwide strike of bank unions, in which about 10 lakh employees of public sector banks (PSBs) participated, Sitharaman’s statement, assuring that “not all” banks would be privatised, clearly indicates that the government will go ahead with privatising select PSBs. 

This is not the first time that the spectre of bank privatisation has been floated as an ostensible solution to the crises in the banking sector. In this reading list, we rebut some of the common arguments made by proponents of bank privatisation and review some of the underlying flawed assumptions about the banking sector.

Myth 1: Poor Governance in Public Sector Banks Is to Blame for the Bad Loan Problem

The PSB performance has deteriorated post 2011–12, thanks to rising non-performing assets (NPAs). In March 2019, NPAs at PSBs were 12.6% of all advances, and the figure for private banks was 3.7%. Return on assets at PSBs was -0.9%, while that at private banks was 1.2%. It is these comparisons that show PSBs in bad light and lead to calls for privatisation.

—T T Ram Mohan (2019) characterised the problem of NPAs or bad loans.

Yet, Ram Mohan has maintained that “the bad loan problem at PSBs cannot be ascribed entirely to poor appraisal or risk management.” He explained:

In the global economic boom that preceded the GFC (global financial crisis), there was a rush to invest and bankers everywhere too got carried along. Following the GFC, cash flows of corporates turned out to be much lower than anticipated, and this was duly reflected in a rise in NPAs. 

He attributed the divergence in the performance of PSBs as compared to private banks, in the period post 2011–12, to the higher exposure of PSBs to five important sectors of the economy: mining, iron and steel, textiles, infrastructure (including power and telecom) and aviation. He highlighted:

In December 2014, these five sectors accounted for 29% of all advances at PSBs and 14% of all advances at private banks.

He further pointed out that the problems in the five most stressed sectors rose largely on account of factors extraneous to management.

Mining has been impacted by adverse court judgments. Steel has suffered because of dumping by China and the absence of reliable fuel linkages. Infrastructure sectors such as power and roads have faced setbacks because of unforeseen delays in land acquisition and environmental clearances. Telecom was thrown out of gear by the cancellation of 2G licences. In general, projections of cash flows for infrastructure proved over-optimistic, consequent to the global financial crisis. 

Similar are the challenges relating to priority sector lending in general, as well. An EPW editorial (2021) explained

Supporters also often cite the larger non-performing assets (NPAs) of the public sector banks to justify privatisation. They, however, choose to ignore the fact that a major reason for this is the social obligation objectives consistently pursued by public sector banks, which bloats their NPAs from priority sector lending to a high of 36.7% as against only 19.7% in private sector banks. In contrast, the share of NPAs from non-priority lending of public sector banks is only 63.3% as against 80.3% in the private sector banks.

While default in key sectors may have led to the problem of bad loans, would it have been preferable if lending to these sectors had been avoided? According to Ram Mohan,

India’s economic boom in 2004–08 was driven by private investment, especially by private investment in infrastructure and related sectors. As the Economic Survey of 2016–17 pointed out, the boom in private investment was financed substantially by PSBs. Is it suggested that PSBs should have limited their exposure to infrastructure and allied sectors as the private sector banks did and focused instead on retail assets? Had they done so, the boom in private investment and the resultant economic boom would not have happened.
 
… the creation of basic infrastructure is primarily the responsibility of the government. Given the fiscal constraints, the government chose to use PSBs to finance infrastructure creation by the private sector. The NPAs that have arisen—and that have necessitated recapitalisation of PSBs—may be seen as deferred financing of infrastructure on the part of the government.

Accordingly, Ram Mohan (2020) concluded that, “PSBs as a category cannot be said to be chronic under-performers or incapable of reform.” 

Instead, analysis by Shubhabrata Basu and Moovendhan V (2017), using panel data regression to investigate the NPAs of 46 scheduled commercial banks between 2007 and 2016, suggested that the asset quality review (AQR) by the Reserve Bank of India (RBI) may have inadvertently victimised PSBs by portraying them as inefficient managers of the NPA crisis relative to their private sector peers. They found

First, contrary to popular perception, PSBs were not found to be inefficient in managing NPA vis-à-vis PVBs (private sector banks). Second, we found that there is evidence to suggest that commercial banks, independent of their ownership pattern, have a priori perception regarding the quality of their assets. However, they appear to declare their assets to be non-performing only when they could provision for the losses. This phenomenon may be more endemic in the PVBs as PSBs, under the impact of AQR, were forced to declare their NPAs. 

Myth 2: Bailing Out Public Sector Banks Is a Drain on the Government’s Capital

One of the most commonly used arguments for privatisation of PSBs is that they impose prohibitive fiscal costs on the government. Scarce government resources that could be used elsewhere are spent on keeping non-performing PSBs afloat.

—Ram Mohan (2019) highlighted another common assumption about the bad loan problem in the banking sector.

He explained how newspaper headlines that report about the capital required by PSBs can be misleading. Newspaper headlines often indicate not the equity capital that the government needs to put in, but the total requirement of equity (from the government as well as private investors) and bonds. According to figures as on December 2020,

The rating agency, Moody’s, estimates that PSBs will need around ₹2 lakh crore of capital over the next two years, or about ₹1 lakh crore in each of the next two years. This translates into ₹50,000 crore of equity capital, of which approximately half or ₹25,000 crore must come from the government. The correct figure to look at is ₹25,000 crore and not the headline figure of ₹2 lakh crore. 

Moreover, the requirements of recapitalisation are not unique to PSBs in India. Ram Mohan explained that governments everywhere have stepped in to rescue private banks as well, a fact which is often overlooked. 

In 2008 and 2009, the United Kingdom (UK) government had to infuse £45 billion (about ₹4,50,000 crore) to rescue the Royal Bank of Scotland. This amount nearly equals the amount spent by India on recapitalising PSBs since the commencement of liberalisation.
 
… The notion that public sector banking systems make endless demands on the exchequer and that these demands somehow would not happen in private banking systems is a sheer delusion. The way banks are designed today, banking systems impose a cost on the exchequer quite independently of ownership. And it is the taxpayer who ends up picking up the costs even under private ownership.

Similarly, Ram Mohan (2001) quoted then RBI deputy governor Y Venugopal Reddy as saying: 

The idea that ‘there is a possible fiscal demand on the government to recapitalise banks and, therefore, you privatise and then the whole world is happy’, is somewhat simplistic, because the health of the banking system is critical for both macroeconomic and fiscal stability. If the banking system, public or private is unhealthy and weak, the hit is on the fiscal since the bail-out has to be publicly funded. We have seen it in east Asia, we have seen it in many other countries, and, therefore, the contention that merely shifting of the ownership from the public sector to the private sector will immunise the possible impact on the fisc is not correct.

Further, in the context of PSBs in India, it is often portrayed by critics that the only reason why PSBs have survived despite having to write off losses from NPAs is state support. And with the fiscal crunch, the government is no more in a position to provide similar support, making mobilising capital from the “market” through sale of new equity that dilutes the government’s shareholding “supposedly the only solution.” Chandrasekhar (2017) debunked such claims:

The fact of the matter is that public banks have survived not because of the support they got from the government. One presumes that support would mean financial assistance to make up for the capital losses that provisioning to write off bad debt would involve. In practice, budgetary support for recapitalisation, of ₹50,000 crore over 2015–16 and 2016–17, was far short of the ₹5 lakh crore of gross NPAs on the books of banks at the end of March 2016, most of which was with the PSBs.
 
But that is not all. A study by the research department of the State Bank of India has found that over the period 2005–06 to 2016–17, while capital infusion into the PSBs was ₹1.29 lakh crore, the dividend paid out by the PSBs was ₹75,000 crore and the cumulative income tax paid was around ₹1.5 lakh crore. More has flowed from the PSBs to the exchequer than from the latter to the public banks. The PSBs have remained in operation despite that, yet the perception is that NPAs in public banks are a drain on the exchequer and could abort the fiscal reform effort of the central government.

Myth 3: Private Banks Invariably Perform Better than Public Sector Banks

Another argument made in favour of privatisation is that: “PSBs have underperformed private banks by a wide margin over the years. So, privatising PSBs would mean a more efficient banking sector.”

Rebutting this argument, Ram Mohan (2020) wrote

Most comparisons of PSB and private bank performance look at a snapshot of a small period, at times of just one year. They compare PSB and private bank numbers on standard metrics—return on assets, net interest margin, non-performing asset (NPA)/total loans, etc—and come to the conclusion that private banks (or new private banks) fare better.
 
A rigorous comparison of performance would cover longer periods. It would also examine whether differences between the two ownership categories are statistically significant. A number of academic studies have made such comparisons for the post-liberalisation period. These studies mostly point to a trend towards convergence in performance in the post-liberalisation period and up to the early 2000s (Ram Mohan 2014).

The divergence in performance has happened in the last decade, 2010–20, that is, after the global financial crisis—owing to various extraneous factors, as explained above.

Further, unlike what the common perception is, private sector banks are rife with issues of misgovernance. An EPW editorial (2021) explained:

[T]he government wilfully continues to obfuscate the fact that inefficient management and corrupt practices by the private sector banks had forced the Reserve Bank of India (RBI) to step in and rescue almost a dozen private sector banks from collapse by merging them with other healthier banks in the last two decades. In fact, the near collapse of Yes Bank, the fourth largest private bank, last year, had badly shaken even the public confidence in the banking sector.

… the experience of some of the oldest surviving private banks like South Indian Bank, Tamilnad Mercantile Bank Limited, Nainital Bank, Karur Vysya Bank, Karnataka Bank, and many others founded in the first half of the last century, hardly inspires any confidence in the ability of the private sector to build large banks. Despite this, the government still apparently wants to hand over the huge assets of the public sector banks to the private sector on a platter, to benefit a few.

Proponents of privatisation also choose to ignore the lessons from the regular collapse of private banks in both the pre- and post-nationalisation phases, including those in the recent decades.

Between 1919 and 1934, as many as 16 banks failed each year on an average. Despite the formation of the RBI in 1935, the number of bank collapses increased around fourfold to average 67 each year till 1948. Though bank failures halved in the next decade to 38 each year, after the Banking Regulation Act in 1949, bank collapses continued to average a high of 30 each year between 1960 and 1969. And even since then, bad management has forced many private sector banks to either merge or collapse, which steadily shrunk the number of private banks from 50 in 1969 to 24 by 1995, when the new-era private sector banks were licensed. Such a poor survival record of private sector banks clearly suggests that relying on them to foster growth is completely unwarranted.

Chandrasekhar (2017) also explained how the case for privatisation of PSBs is ahistorical and fails to see why public banking came into existence in the first place. 

Nationalisation was unavoidable because, despite repeated efforts of the government, private promoters of banks who put in little by way of equity, diverted public savings to projects in which the promoters had a direct or indirect interest. Agriculture and the small-scale sector were starved of credit. In an effort to cut costs at the expense of inclusion, privately owned banks limited their branching and restricted their activities to cities. Finally, with exposure to a few projects that interested the promoters, many banks were vulnerable and fragile. So growth, inclusion and stability pushed the government to take over the Imperial Bank of India in the 1950s and a host of other commercial banks in 1969 and after.

In this light, what is often overlooked is that there is another fundamental metric of performance evaluation wherein public sector banks far outperform private banks: financial inclusion. According to the EPW editorial (2021):

Today, the number of rural branches of public sector banks are four times larger than that of private sector banks, as they locate a third of their branches in rural areas unlike private sector banks that locate just one-fifth of their branches there.

Therefore, an attempt to assign a larger role to private banks would be a major setback to the extension of banking infrastructure to underserved and unserved areas. The editorial further explained:

[T]he government refuses to acknowledge the huge contributions of public sector banks and also ignores the lackadaisical performance of the private sector banks, which, except in the case of a few outliers, continue to largely focus operations in urban areas and on high-end users who can afford to pay their exorbitant charges. In fact, even today the complaints against overcharging without prior notice by private sector banks far outnumber those against public sector banks. So, privatisation and a larger market share of private sector banks would only end up in increasing the costs of banking services without any other significant commensurate benefits.

Myth 4: Privatisation Is the Only Solution to the Banking Crisis

The Narendra Modi government appears to have decided to privatise public sector banks (PSBs). Preparations are underway with arguments being marshalled that “there is no alternative” to privatisation. 

observed C P Chandrasekhar (2017). But is there no alternative to privatisation? 

With the merits of the private sector themselves questionable, as analysed above, it is clear that privatisation is neither feasible nor desirable. While there is no denying that there is scope for improving the performance of PSBs, it cannot be said that public sector banks cannot be reformed without changing the nature of their ownership. 

Ram Mohan (2018) contended that the government, as the majority owner, may continue to exercise control, but it must do so through its nominees on the board, so that decision-making is transparent and decisions are properly debated.

The governance problem at PSBs is not that of the government exercising control per se. It is that the government exercises control by circumventing the board and through direct contacts between the Ministry of Finance and the top management of banks. This must end. The government can empower boards by expressing its views through its representatives on the board.

Explaining that the choice of wrong persons for top management positions has been the principal bane of PSBs in the past decade, Ram Mohan observed:

It is also necessary to end the game of musical chairs at the top level in nationalised banks. At State Bank of India, which stands out among the PSBs in terms of performance, individuals rise from the level of probationary officer to the post of chairperson. Not so at other PSBs. Executive directors hop to the managing director’s position at other banks. Rotation among banks up to the level of the executive director is acceptable. It should not happen at the level of the managing director. It is best that the managing director is chosen from amongst one of the executive directors at a bank. Then, we have continuity, familiarity with bank culture, and a measure of commitment.

With regard to governance of PSBs, Ram Mohan (2019) listed specific reform proposals:  

One, we need better directors on PSB boards. The compensation of independent directors of PSBs must be raised. The RBI can lay down more stringent “fit and proper” criteria for all board members of PSBs, including government appointees. Two, the quality of appointments of managing directors (MDs) at PSBs also needs to be improved, and some improvement has already happened under the auspices of the BBB. Three, delays in the appointments of MDs and executive directors (EDs) at PSBs must be avoided through proper succession planning. The RBI can help here too by introducing penalties for undue delays in senior appointments. Four, succession planning at PSBs must involve some opportunities for internal promotion to the posts of MD and ED; all appointments do not have to be from outside. Five, variable pay for top management at PSBs can be introduced along the lines of those that obtain at PSEs (public sector enterprises). In other words, there is ample scope for improving performance within the framework of government ownership.

Barring the sine qua non of recapitalisation, and the proposals for strengthening of bank boards and the top management, another area of reform identified by Ram Mohan (2018) is the Insolvency and Bankruptcy Code (IBC). While the IBC was envisaged to streamline the resolution process for NPAs, as many as 34% of cases in the bankruptcy courts (up to June 2019) were delayed beyond 270 days. Ram Mohan noted:

[T]he government needs to devise alternative mechanisms to the IBC route for resolution of bad loans. Despatching all bad loans to the NCLT is likely to result in delayed resolution and poor recovery, as bad loans clog up the NCLT system and there are not enough bidders for the vast majority of loans.

… bank-led resolution and setting up an Asset Management Company (AMC)—must be welcomed. Banks must be able to resolve some of their bad loans on their own through negotiations with borrowers. In the case of some stressed assets, such as those in the power sector, it is useful to have recourse to a mechanism such as an AMC that would nurse the assets back to health before sale is attempted.

Read More

Why Corporate Houses Should Not be Allowed to Promote Banks: A Reading List | EPW Engage, 2020

Public Sector Banks in India: Should They Be Privatised? | K B L Mathur, 2002

Comparing Performance of Public and Private Sector Banks: A Revenue Maximisation Efficiency Approach | Subhas C Ray and T T Ram Mohan, 2004

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