Reprivatizing public sector banks (PSBs) never seems to be on the table in India. I contend that it should be at this point of time.
Until five years back, the price-to-book ratio of most PSBs was less than 1, in part due to not having fully recognized non-performing assets (NPAs) and not marking impending losses. It was considered inopportune then to discuss reprivatizing PSBs, akin to selling the family brassware for scrap value.
Things have changed. Losses are now more or less fully recognized. Significant capital injections have been made by the government. As per the bank balance sheets for the March quarter, seven PSBs—including the largest one—have less than 1% of loan advances in net NPAs, i.e., NPAs that are not provisioned for. None of the PSBs are anymore under the Reserve Bank of India (RBI)’s Prompt Corrective Action framework which imposes lending restrictions.
With the Insolvency and Bankruptcy Code being actively used to resolve defaulted debt, corporates have deleveraged and fresh NPA slippages have come to a trickle. Management at PSBs has had the opportunity to rebuild balance sheet strength rather than simply focus on evergreening of distressed borrowers or punt on treasury gains by investing in government bonds.
Recognizing these positive developments, capital markets have rewarded the valuation of PSB stocks, and their price-to-book ratio is now more than one on average. The government should take all the credit it deserves for this turnaround and start reprivatizing the PSBs without much ado. Let me provide five compelling reasons.
Firstly, PSBs were nationalized over 50 years back. The then government wanted its own ‘foot soldiers’, namely loan officers, providing credit in the nooks and crannies of India rather than to large corporates. The political objective was to attribute to the government’s developmental progress; the stated objective was financial inclusion. Neither was achieved to satisfaction for over four decades. Eventually, and only over the last decade, Jan Dhan Yojna accounts, Aadhaar and the Unified Payments Interface (UPI) have delivered to near-completion the financial inclusion agenda.
Given India’s successful digital finance foray, the incremental gain on financial inclusion from retaining a controlling government stake in all PSBs is likely to be minuscule. Indeed, the government has figured out how to do welfarism better, and to do more of it, by relying on modern technology and direct benefit transfers, eliminating the need for banking ‘middlemen’. Under these circumstances, one, or at best two, PSBs with a nationwide presence should suffice to meet any future financial inclusion goals and needs.
Secondly, and somewhat paradoxically, PSBs amassed NPAs decade after decade in each boom-and-bust cycle of leverage, precisely by lending to large corporates. This occurred often at the behest of past governments and against the purported objectives behind nationalizing them. Mercifully, it is now accepted by most within the government and various ministries that using PSBs to pump-prime the economy by blessing or requiring poorly underwritten credit is perilous. It exposes the country to the risk of anaemic credit growth for several years thereafter.
For now, PSBs seem to have been exonerated from performing the dubious political function of connected or election-cycle lending. What exactly then is the political gain from retaining their complex ownership and management functions in the finance ministry? By shedding control, the government would send a credible signal to the world that it means business when it promotes the mantra of “minimum government, maximum governance.”
Thirdly, even though PSBs have restored their balance sheet health, their price-to-book multiple is a whole point below that of Indian private banks, whose multiple exceeds 2 on average. Ordinarily, in a competitive industry, such large and near-permanent differences would be hard to reconcile unless entities with lower valuations are simply failing. Therein lies the catch.
Private banks are in fact the biggest beneficiaries of the continuing existence of PSBs. That PSBs are subject to bureaucratic red tape in decision-making, face restrictions in offering attractive pay packages, and are slow to invest in technology to better service the customer base, are massive competitive advantages to private banks.
Unsurprisingly, private banks have been growing their deposit base faster than the PSBs year after year, without having to compete too hard on deposit rates. In turn, their intermediation margins remain at levels typical of an oligopoly, making them the darlings of stock market investors. At times, private banks can afford to not grow their credit book as much as there is demand, instead retaining lower scale but higher margins as they do not need to scramble for deposits. The resulting low deposit rates are likely one reason why equity and housing investments seem so attractive to Indian savers.
In response, many PSBs have evolved into passive equity fund managers, but there is no need for them to be government-owned to perform this function. Reprivatizing PSBs will thus be tantamount to levelling the playing field in India’s banking sector. It will raise their own margins and valuation ratios, and bring to Earth those of private banks. Credit, private investment and high-quality employment growth will be the real winners.
Fourthly, even as the government has improved its tax collections, welfarism has grown popular in its modus operandi. It has expanded on infrastructure spending in parallel. The country’s fiscal deficit therefore continues to remain high and is funded and rolled over in the bond markets. Reprivatizing PSBs below controlling stakes would not only unleash their repressed growth, it would also raise substantial divestment proceeds, stabilize government finances further and be seen as another step forward in upgrading the country’s sovereign credit rating. Indeed, privatizing other parts of the financial sector, such as insurance and power-sector finance, should also be considered as steps in unison.
Finally, over the past more than 20 years, India has embraced change and modernized its corporate sector. Relinquishing state control of enterprises has been a key pillar of this transformation. However, the financial sector, and banking in particular, continues to retain a significant government footprint.
The financial sector must also now be modernized. If India is to realize its immense potential and demographic dividend, the financial sector should in fact lead the way and help accelerate the growth impulses of the real economy. Distracting patchwork-style reforms won’t cut it anymore. For instance, playing musical chairs in the form of PSB mergers has kept everyone amused and guessing. Hopefully, some synergies have materialized. The music for that game has however stopped. It is time for more serious reforms. With attractive price-to-book ratios that were unthinkable five years back, the divestment ministry’s Pavlovian inertia to taking any significant privatization decision appears evidently surmountable.
Changes in PSB ownership and style of management will undoubtedly entail some risks. But these risks can be managed. RBI has shown itself over the past decade to be swift in recognizing banking fragility and adept at addressing it. All things considered, I cannot think of a better moment for the government to start reprivatizing the PSBs.
Viral V. Acharya is a professor of finance at New York University Stern School of Business and a former deputy governor of the Reserve Bank of India.
