It’s time to privatise banks: India’s public sector banks have become a major threat to nation’s economy

The Rs 11,000 crore ($1.4 billion) fraud involving the Punjab National Bank is another nail in the coffin for government-run banks in India. Add to this the fact that 90 per cent of the Rs 10 lakh crore of bad loans on the books of Indian banks belong to government-run banks, and you have a compelling case for privatisation of all banking in India.

It is hard to put a number on the magnitude of the scam that public sector banking has imposed on the people of India since India’s experiment with nationalisation in July 1969. It is no secret that successive governments have treated public sector banks as a money machine to fund their elections and to reward their cronies. People with access to the levers of government power have made off with billions of dollars of public money. The modus operandi for looting banks would make the bank-robbing duo of Bonnie and Clyde look like bumbling amateurs. A letter from a minister or a bureaucrat, a small slice of the pie as gratitude for the bank manager, and off you go with a bank loan that you never have to pay back. This scam has been going on for years, and very few people have been caught or punished to date.

It is only recently that the issue of bad loans has become public, thanks to an aggressive Reserve Bank of India (RBI) under Raghuram Rajan. Previously, bad loans were rolled over and hidden away on the balance sheet. In March 2012, for example, bad loans at government banks stood at about Rs 112,000 crore. But ever since the RBI started the Asset Quality Review, which forced banks to report bad loans, the magnitude of bad loans has suddenly jumped to almost Rs 800,000 crore – an eight-fold increase in less than six years. The size of this jump in bad loans defies credulity in an economy, touted as the fastest growing economy in the world. All these bad loans did not just suddenly transpire – it’s just that this is the first time people have been caught with their hands in the cookie jar and have been made accountable. It is not a coincidence that Rajan’s contract at RBI was not renewed.

The endgame with India’s public sector banks could be drawing near. Not only are they losing money (the December 2017 quarterly loss was State Bank of India’s first reported quarterly loss in 17 years), but worst is that neither they nor anyone else knows how much they have lost. No one knows if the PNB fraud is an isolated case or a pattern of systematic fraud that may eventually surface. So not only are Indian public sector banks insolvent, no one really knows how big a hole they are in.

The bottom line is that government banks in India are a major threat to the Indian economy. The modern banking system with its practice of fractional-reserve lending in which a Rs100 deposit creates loans worth Rs 1,000 of loans depends crucially on the integrity of the lending process. It is vital that capital is channelled to its most productive use based on economic realities and not as a result of government interference. Banks have to decide on the riskiness of a loan based on the projected cash flows from the use of capital. Without the discipline imposed by risk-based lending, capital gets routed away from productive activities into creating asset bubbles.

This concern was pointed out by the RBI in its bi-annual Financial Stability Report released in June 2017 where it acknowledged that the banking sector was under severe stress, with mounting bad loans and an increase in bank fraud. The failure of one bank could lead people to worry about the financial position of other banks. This can lead to a domino effect – a bankruptcy at one bank can lead to a ‘cascade’ of defaults, bank runs and insolvencies as people panic. All this, the RBI said, could drag down India’s economy.

It is time to admit that the nationalisation of banks has been a failure. Reprivatisation of India’s banking industry should now be at the front and centre of this government’s agenda. After all, PM Narendra Modi campaigned for limited government – it is the time to put that promise into action. Private banks will bring innovations in products, technology and customer servicing and a market-based discipline to lending. Private banks, knowing that they cannot count on government’s protection, are unlikely to engage in the sort of risky lending that characterised public bank lending. Also, they will not be subject to the same pressure from politicians and others in government that has destroyed the public sector banks.

The primary justification for bank nationalization – serving the rural parts of India – is no longer relevant with the rapid growth of small banks, payments banks, microfinance institutions and with many private banks eager to tap the rural market today. With India’s experiment with socialism thankfully in the past, it is also time to bury government-run banking. At the very minimum, the government should implement the recommendations of the PJ Nayak committee and transfer its shares to a Bank Investment Company (BIC), with functional autonomy. At least this will prevent the government from appointing directors and senior managers and mitigate the state’s interference in the lending process.

The author is the founder, contractwithindia.com. Views expressed are personal.