File photo of Raghuram Rajan
File photo of Raghuram Rajan | PTI photo
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The banking system is overburdened with non-performing loans. Much of the problem lies in public sector banks, but private sector banks like ICICI and Axis Bank have not been immune. Some of the malaise comes from a general need to improve governance, transparency and incentives in the system. However, the difficulties in even some private banks suggest that ‘simple’ solutions like privatizing all public sector banks may be no panacea.

At any rate, banking reform should tackle four broad areas:

Reviving projects that can be revived

The National Company Law Tribunal will help restructure debt for the largest firms and projects under the Bankruptcy Code. However, the NCLT will be overwhelmed if every stressed firm or project files before it. Instead, we need a functional out-of-court restructuring process, so that the vast majority of cases are restructured out of bankruptcy – with the NCLT acting as a court of last resort if no agreement is possible. Both the out-of-court restructuring process and the bankruptcy process need to be strengthened and made speedy. The former requires protecting the ability of bankers to make commercial decisions without subjecting them to inquiry. The latter requires steady modifications where necessary to the Bankruptcy Code so that it is effective, transparent, and not gamed by unscrupulous promoters. Of course, for many projects, financial restructuring is of little use if the project cannot proceed for other reasons such as lack of land or permissions or input supply. Any new government will have to give priority to rectifying these issues. I will not go into details here since some of these bottlenecks are covered in other notes.

Improving governance and management at public sector banks

  • Public sector bank boards are still not adequately professionalized, and the government rather than a more independent body still decides board appointments – with the inevitable politicization. The government could follow the P.J. Nayak Committee report more carefully.

Eventually strong boards should be entrusted with all bank-related decisions, including CEO appointment, but held responsible for performance. Strategic investors could help improve governance.

  • Risk management still needs substantial improvement in public sector banks, regulatory compliance is inadequate and cyber risk needs greater attention. Interest rate risk management is notable for its absence, which means banks are very dependent on the central bank to smooth the path of long-term interest rates. These are all symptoms of managerial weakness. There is already a talent deficit in internal public sector bank candidates in coming years because of a hiatus in recruitment in the past. Outside talent has been brought in very limited ways into top management in public sector banks. This deficiency needs to be addressed urgently by searching more widely for talent. Compensation structures in public sector banks also need rethinking, especially for high-level outside hires.

Privatize or not?

Is privatization of public sector banks the answer? Much of the discussion on privatization seems to make assumptions based on ideological positions. Certainly, if public sector banks are freed from some of the constraints they operate under (such as paying above the private sector for low-skilled jobs and paying below the private sector for senior management positions, having to respond to government diktats on strategy or mandates, or operating under the threat of CVC/CBI scrutiny) they might perform far better. However, such freedom typically requires distance from the government. So long as they are majority-owned by the government, they may not get that distance. At the same time, there is no guarantee that privatization will be a panacea. Some private banks have been poorly governed. Instead, we need to recognize that ownership is just one contributor to governance and look at pragmatic ways to improve governance across the board. There certainly is a case to experiment by privatizing one or two mid-sized public sector banks and reducing the government stake below 50 per cent for a couple of others, while working on governance reforms for the rest. Rather than continuing a never-ending theoretical debate, we will then actually have some evidence to go on. Some political compromises will be needed to allow the process to go through, but so long as the newly privatized banks are not totally hamstrung in their operational flexibility as a result of these compromises, this will be an experiment worth undertaking.

Merge or not?

An alternative proposal to improve governance is to merge poorly managed banks with good banks. It is uncertain whether this will improve collective performance – after all, mergers are difficult in the best of situations because of differences in culture. When combined with differences in management capabilities, much will depend on whether the good bank’s management is strong enough to impose its will without alienating the employees of the poorly managed bank. We now have two experiments under way: State Bank has taken over its regional affiliates, and Bank of Baroda, Vijaya Bank and Dena Bank have been merged. The performance of the latter merger will be more informative. Thus far, market responses suggest scepticism that it will play out well. Time will tell. De-risk banking by encouraging risk transfers to non-banks and the market Too many risks devolve on to banks, including risks such as that of interest rate volatility that banks elsewhere typically lay off in markets. Too much project risk stays with banks because other financial instruments such as equity and subordinate debt cannot be issued cheaply. Risk also returns through the back door. For example, banks do not make loans to housing developers because of their intrinsic risks. But they do make loans to non-bank financial companies, which make loans to developers. To prevent risk from returning to bank balance sheets, NBFCs must be able to raise money directly from markets. Financial market development, addressed in Eswar Prasad’s note in this volume, will help banks focus more on risks they can manage better and thus bear more effectively, while sharing or laying off what they cannot. Banks will have to complement financial markets rather than see them as competition. The use of financial technology will be especially helpful to them in this endeavour.

Reduce the number and weight of government mandates for public sector banks

Uncompensated government mandates have been imposed on public sector banks for a long time. This is lazy government – if an action is worth doing, it should be paid for out of budgetary resources. Mandates also are against the interests of minority shareholders in public sector banks. Finally, it does not draw the private sector in to compete for such activities. The government should incentivize all banks to take up activities it thinks desirable, not impose it on a few – especially as the privileges associated with a banking licence diminish. Along these lines, requirements that banks mandatorily invest in government bonds (the SLR requirement) should continue to be reduced, substituting them instead with the liquidity coverage ratios and net stable funding ratios set by Basel. Among the more dangerous mandates are lending targets and compulsory loan waivers. Government-imposed credit targets are often achieved by abandoning appropriate due diligence, creating the environment for future NPAs. Loan waivers, as the RBI has repeatedly argued, vitiate the credit culture and stress the budgets of the waiving state or Central government. They are poorly targeted, and eventually reduce the flow of credit. Agriculture needs serious attention, but not through loan waivers. An all-party agreement to this effect would be in the nation’s interest. Finally, the government should keep its banks well capitalized, conditional on improvements in governance and management efficiency. This is simply good accounting practice, for it prevents the government from building up contingent liabilities on bank balance sheets that a future government will have to pay for.

The Solutions

  1. The P.J. Nayak Committee recommended a path to greater independence for public sector banks, and its ideas should be implemented. Eventually, public sector bank boards should be independent and accountable, and allowed to choose the banks’ CEOs.
  2. Banks need to build up more in-house talent for such specialized tasks as managing project finance. Public sector banks may have to start paying more to attract world-class talent.
  3. Some mid-sized public sector banks should be privatized as a test case.
  4. Banks should not be forced to implement the government’s policy priorities. In particular, an all-party agreement that loan waivers should be avoided is in the national interest.

This excerpt from What The Economy Needs Now edited by Abhijit Banerjee, Gita Gopinath, Raghuram Rajan and Mihir Sharma has been published with permission from Juggernaut.

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2 COMMENTS

  1. The “ Solutions “ listed in the Column are unworthy of a former CEA and RBI Governor. They could have been made by an academic, not someone who has had a lofty insider’s view. 2. Does Dr Rajan honestly believe the government – any government – will implement the airy – fairy recommendations of the P J Nayak Committee, culminating in an “ independent “ Board selecting the CEO. Banks not implementing the government’s policy priorities, MUDRA, farm loan waivers, no more loans in the tens of thousands of crores to selected business houses. 3. The first time Dr Rajan precluded privatisation as a solution to the problems of the PSBs – this was a few months back – I figured he had had a conversation with the Congress President who had told him that his grandmother’s signature initiative was a holy cow that could not be sacrificed. 4. What makes me sanguine about genuine reform taking place is that circumstances will make it unavoidable. Then, if a neurosurgeon is not on hand, a butcher will get the job done.

  2. Unable to understand what is new or out of the box solution in this note, except that this comes from an internationally well known economist like Rajan. These issues and solutions have been discussed and debated time and again and nothing has been done so far. Modi needs to take control of Finance Ministry if he forms the next government and implement these well known solutions, now approved by top class economists ( (who have also authored Nyay scheme of Congress!) without any delay. Jaitley was reluctant to move on banking reforms and he needs to be given some other portfolio now.

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