Pick apart this myth

Indian Express, 4 November 2009

Hindutva supporters make claims about how many of the technological advances of the West were known in Ancient India. Bank nationalisation by Indira Gandhi is acquiring a similar status today. The West, it is claimed, is now trying to make its financial system safe by embracing bank nationalisation. This narrative claims that our wise sages knew this all along. We anticipated meltdowns like those of 2008 and nationalised our private banks much ahead of time in 1969.

To set the record straight, let us begin with what the West is doing. Northern Rock in the UK was the first significant "nationalisation" in the current crisis. The UK government has subsequently passed the SRR (Special Resolution Regime) for failing banks. The SRR provides the UK authorities with the power to place a failing bank into "TPO" which stands for "temporary public ownership". The public document released alongside it, arguing for a case for such a regime, says that, "Had the authorities been able to have placed Northern Rock into an SRR at an earlier stage, when more of its value remained, it is possible that part or all of the bank could have been sold to a private sector buyer. This would have avoided the need to impose additional potential losses on the taxpayer by having to nationalise the bank." In other words, the UK was an unwilling nationaliser. The conditions under which the banks have been put in public ownership, largely as a move to enhance their capital and to provide confidence among depositors, are very different from nationalising banks with the intent to run them and pre-empt credit and resources. In the West, when these banks become healthy, they will be privatised. There are no plans of the UK Treasury setting up a banking division to do their corporate governance.

Now let us turn to the benefits of public sector banks. While it is true that public sector banks are considered safer by depositors as they have a soverign guarantee, this guarantee does not come free. These banks can take on larger risks knowing that they will be bailed out. Moreover, their political owners generally interfere in the process of giving out loans. This can give bigger risk in the system, and constitutes a non-transparent mechanism for politicians to steal money from the exchequer (i.e. the shareholder of PSU banks).

Among the benefits of public sector banks, one sometimes hears the absurd claim that they provide employement. The larger employement generated by PSU banks is a cost to the economy. PSU banks have much lower productivity than private banks. The profit per branch of public sector banks is Rs 0.5 crores, a fifth of the Rs 2.5 crore for private banks. The profit per employee at Rs 2.6 lakhs is only a third of the Rs. 7.6 lakhs for private banks. This is despite much higher wages at private banks. They lag behind on efficiency and profitability thereby making financial intermediation costly for the economy. This reduces growth and productivity in the Indian economy.

However, as the Raghuram Rajan report argues, if efficiency and profitability are not the correct yardsticks by which to measure the success of public sector banks, and "social goals" such as financial inclusion and credit to the priority sector are the right objectives to look at, PSU banks have failed even on those. India continues to have a very poor performance on financial inclusion, even though a certain recipe of bank nationalisation, directed credit, etc. has been tried for many decades.

While in the seventies and eighties, opening branches to raise deposits may have been a priority, today the experience of many countries, including India, has demonstrated that access to credit is very important in the reduction of poverty as it helps smooth consumption. It is claimed that the right way to get this done is to force PSU banks to open rural branches. Empirical evidence shows that these approaches are not delivering results. In addition, these old approaches have failed to take into account India's urbanisation and the increasingly important needs of financial services by the urban poor. The anti-competitive policies of the authorities, such as preventing branch opening or preventing the entry of new private banks, directly hurts the agenda of improving access to finance for the urban poor.

The US banking system erred on the side of too little caution. There was perhaps too much inclusion. Too many poor people got housing loans. We have erred on the side of too much caution. Banks are reluctant to give loans where there is risk. They would rather be safe and lend to the government or large companies. The opportunity of cost of this strategy has been lost growth and continuing poverty for many decades. If we look at only the safety aspect of the Indian banking system in isolation, we make the mistake of thinking all is well. This leads us to the mistake of continuing with a financial system that fails to provide for the needs of the growing economy and large mass of urban and rural poor.

In all these years of economic policy distortions, we have forgotten the primary objective of banking was. It was to provide entrepreneurs with credit to do business. PSU banks lend upto one-third to half the deposits they raise to the government. The rest gets taken up by various social objectives. Instead of thumping our backs about a safe banking system, we need to focus on creating a system which provides credit to those who need to. It is better to have a fully private banking system, and occasionally nationalise a few banks in a crisis, than to nationalise the entire banking system, and in the process not have an efficient and inclusive banking system.

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