The Reserve Bank of India released the financial stability report recently emphasising that economies around the world were experiencing uneven growth, deflationary pressures, and geopolitical risks. In such a situation, no country is immune to policies being pursued in other countries, especially in the advanced economies. Though India is a bright spot in world in terms of growth, its banking sector, which mirrors stress in corporate sector, continues to be a cause of concern.

The risks to the Indian banking sector have increased recently on account of deterioration in asset quality and low profitability, while credit and deposit growth have slowed significantly. A risk profile of select industries as on end March 2016, showed that iron and steel, construction, power, telecommunication, and transport, having high leverage ratios, can exert pressure on the deteriorating asset quality of bank loans.

Stress matters

The stress tests on banks indicate that gross non-performing assets (GNPAs) may deteriorate further to 8.5 per cent by March 2017 from 7.6 per cent in March 2016 and 5.1 per cent in September 2015. However, if macro situation deteriorates further, GNPAs could rise to 9.3 per cent by March 2017.

The RBI has undertaken measures to enable banks to identify asset quality, timely restructuring of viable assets and recovery of unviable assets. In this context, Governor Raghuram Rajan recently observed that there was a need to clean up balance sheets of public sector banks (PSBs). He mentioned that a number of loans which led to stressed assets in recent years were made in 2007-08 when economic growth was strong and opportunities were limitless. In that extraordinary exuberance, banks made mistakes in extending loans without ensuring due diligence in evaluating proposals.

Illustratively, Governor observed in his recent speech: “One promoter told me about how he was pursued then by banks waving cheque books, asking him to name the amount he wanted.” He also acknowledged that there have been instances of malfeasance, and investigating agencies are pursuing some such cases.

The GNPAs in PSBs are significantly higher than private sector and foreign banks. The sectors recording stressed advances are infrastructure, construction, engineering goods, basic metal and metal products, cement, paper and paper products, textile, food processing and mines — all of them running up a stressed advances ratio of more than 16 per cent of the advances to their respective sectors. Profit after tax for PSBs in 2015-16 was negative (loss) 118 per cent over the previous year while private sector banks witnessed a growth of 11.6 per cent.

Granularly, bank-wise, final annual results of many PSBs for fiscal 2015-16, were poor. The Government, as owners of PSBs, has been initiating various steps such as strengthening the selection process of the top management, setting up a stressed assets fund and recovery tribunal, and legislating a bankruptcy code. The Government has already allocated sufficient funds to recapitalise the banks over next few years.

Privatising PSBs

Issues related to consolidating the Indian banking sector have been debated for years. Mergers have been a preferred suggestion. In India, many banks in the past were merged with other banks. New Bank of India and Punjab National Bank, both PSBs, were merged in 1993. Recently, the Government announced the merger of State Bank of India and its associates.

Mergers can be successful in similar institutions with a similar culture, but cannot be extensively adopted because it leads to job cuts, branch closures and in some cases, a lowering of the quality and quantity of services. Hence, in addition to mergers, the Government would need to consider other alternatives.

The government could explore setting rigorous standards for banking industry — privatising some of the inefficient loss-making PSBs while rewarding profit making PSBs. Many countries have privatised their nationalised banks, including some from the erstwhile Eastern bloc countries. Argentina, Australia, Brazil, Bulgaria, Chile, Denmark, Egypt, Finland, France, Hungary, Indonesia, Italy, Korea, Mexico, Norway, Poland, Peru, Spain, Sweden, Tanzania, Turkey, Venezuela and many more have privatised their banks over the years.

The method of privatisation has varied across countries, especially in transition economies of former Soviet Union where voucher privatisation was undertaken with an objective of egalitarian distribution to citizens. In Finland, the method was privatisation by asset sales.

The most widely used method is by offering an IPO which serves to foster capital market development. But widely held ownership has the drawback of not providing strong oversight of management by a significant shareholder. It may not ensure strong management and robust internal systems. Further, in countries with small and emerging capital markets there is a chance of market manipulation, too. Better financial performance is ensured when a strong financial institution is involved as a significant shareholder in privatisation.

The social angle

Privatisation implies that the 60-year-old policy of social control needs to be reviewed. In India since 1991, PSB have been tapping the capital market, but have not been privatised. In 1999, after review, privatisation was considered impractical and expensive due to inability to attract private investors as well as cost of restructuring.

Privatisation of PSBs is not going to be easy, as it would involve building consensus amongst various stake holders, including unions and parliamentarians. The decision to privatise inefficient PSBs, consistently delivering negative returns, would require wide debate.

Therefore, it would be useful to have a high-powered, government-appointed committee, to devise exact criteria, modus operandi , the type of privatisation model to be adopted, and engage with the social ramifications before privatisation is actually undertaken.

In India, PSBs enjoying a gilt-edged status, should serve as benchmarks for the banking sector. To ensure that PSBs work at their efficient best, given that tax payer’s money is at stake, there is need to establish very high standards; else, privatisation should be an alternative. As Planning Commission was the vestige of socialist pattern of society, so is social banking. And the time to revisit it is now!

The writer is RBI Chair professor of economics at IIM Bangalore. The views are personal