Why privatisation of public sector banks won't work

Shekar Swamy | Updated on September 29, 2020 Published on September 28, 2020

US private banks fail routinely and are bailed out with public funds. Rajan, Acharya should know our depositors deserve better

Raghuram Rajan and Viral Acharya, former governor and former deputy governor of the Reserve Bank of India, get a lot of play in the Indian media. Recently, they published a research paper —‘Indian Banks: A Time to Reform?’ on September 21 which has been widely reported. Both the authors have had enough exposure and access to information about the harsh events that have taken place in the world of finance and banking.

So, when they write a paper, one would expect these experiences provoke a thoughtful reflection. It amounts to a shocking failure of academic rigour and integrity that the prescriptions given in the paper, euphemistically called reforms, become unidimensional, looking at one aspect of banking and completely ignoring the needs of the most important stakeholder.

Rajan and Acharya say that due to the pandemic, India cannot afford to fund its banks. The dimension they focus on is credit growth and management of loans — the assets side of the banks’ balance sheet. Therefore, one of their prescriptions is the oft-repeated agenda of Big Capital, which is the privatisation of Indian banks and handing over the banking system to investors. The authors identify these investors on page 24 of their paper: “It might be especially valuable if these investors have financial sophistication (a foreign financial firm or a domestic private bank) and technology sophistication (a fintech firm or a technology-focused private equity investor)” (emphasis mine).

Rajan and Acharya’s paper includes many recommendations under different heads such as ‘Dealing With Bad Loans’, ‘Improving Performance’, ‘Alternatives For Ownership Structure of Banks’, ‘Strengthening Risk Management’ etc.

Let’s, for now, look at the proposal to privatise public sector banks.

The question of ownership has to be seen first from the perspective of the most important stakeholder in banks — the depositor. This is the liabilities side of the banks’ balance sheet, the side ignored by Rajan and Acharya. There are around 2.5 billion current and savings accounts in Indian banks. This is the source of money for the banks to lend. The loans extended by banks would be less than 10 per cent of this number, including credit card loans.

A bad idea

Privatisation of banks is a terrible idea from the depositors’ point of view for reasons given below:

1) Private players in the financial sector are prone to failure: The world felt the shock waves as the financial markets collapsed in 2008, caused by over-reaching private players. In what has been documented copiously as the subprime mortgage crisis, this resulted in the biggest economic downturn since the great depression of the 1930s hurting millions of people.

A deeper crisis was averted only with the US Federal government, and other governments, providing the bailout. What is remarkable about this crisis is this — not one banker or executive of a financial organisation went to jail for this extraordinary level of fraud imposed on the world. Rajan and Acharya are advocating that Indian banks should be handed over to investors and private players with a similar DNA.

2) Private banks fail all the time: The website of the US Federal Deposit Insurance Corporation (FDIC) — an independent body created by the US Congress to maintain stability and public confidence in financial system — carries this information prominently. In the 20 years from 2001 to 2020, as many as 559 private banks with assets of $721 billion failed in the US (see chart). What happened to the depositors? It was the problem of the FDIC to bail them out.

The principle followed by private banks is this. When they make profits, it goes to shareholders. When they make losses, it gets socialised and falls in the lap of the government to make good the deposits either through insurance or taxpayer bailout. This has happened again and again. This is what Rajan and Acharya are prescribing as reforms.

3) Big private banks can fail any time: There is a myth that if a bank gets large enough, it will not fail. Wrong. While one can agree that the larger the bank, the greater its ability to absorb losses, this does not mean it cannot fail. The axiom “Higher you go, harder the fall” applies best to private banks. This year we were all witness to the failure and subsequent reorganisation of YES Bank.

Let’s take some bigger examples.

Citibank: Founded in 1812, this is an outstanding example of how large banks fail and get rescued by taxpayers. In 1998, Citicorp merged with Travelers to form Citigroup to be hailed as the first modern American “universal bank” that could offer comprehensive banking, securities and insurance services to its customers.

Within a decade, Citi’s strategy proved to be disastrous. The bank recorded more than $130 billion of write-downs on its loans and investments from the second half of 2007 through the end of 2009.

To prevent Citigroup’s failure, the US government injected $45 billion of new capital into the bank and provided it with $500 billion of additional help in the form of asset and debt guarantees, and liquidity assistance. Citibank survives today thanks to its bailout with public money.

Washington Mutual Bank: Washington Mutual is the largest bank failure in US history. The bank was wound up after 119 years; private bank failure can happen at any time no matter how large. In 2004, WaMu was the sixth-largest bank in the US and a leading mortgage lender with $300 billion in assets, $188 billion in deposits, 2,300 branches in 15 states, and over 43,000 employees. By 2006, following a high growth strategy, WaMu’s loans began incurring record rates of default, and its securitisations saw ratings downgrades and losses.

In 2007, the bank went into the red. Its shareholders lost confidence and depositors began withdrawing funds, causing a liquidity crisis. In September 2008, WaMu was seized by its regulator and sold to JP Morgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the $45 billion Deposit Insurance Fund.

There are countless examples of failures of private banks all over the world. Rajan and Acharya advocate privatisation because they say India cannot fund its banks due to the pandemic. Pandemic or not, hundreds of millions of Indians are not worried stiff if their bank deposits are safe, thanks to the sovereign ownership. Isn’t that something?

The writer is Group CEO, RK Swamy Hansa. Views are personal

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Published on September 28, 2020
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