Why Arun Jaitley should no longer shun the P word - privatisation

No government in India has ever been short of economic problems to solve. The UPA, after a rain of good luck in its first term, tripped on every possible challenge in its second. Narendra Modi’s NDA did not inherit a sound economy, but it has been fortunate that oil prices are behaving and the feared severe monsoon deficit does not look that bad anymore.

But bad luck is coming from another direction: a banking crisis led by a build-up of bad loans and an eruption of loan scandals - as the Syndicate Bank-Bhushan Steel bribery case, the Dena Bank and Oriental Bank fraud cases attest.

The crisis cannot be solved by palliatives. It needs deep structural corrections, including a slow and steady exit of the government from running banks.

The bad loan crisis is not a stray or sudden affliction - it is a systemic issue, the result of the deep nexus between political, corporate and private vested interests. For decades now Indian entrepreneurs have been investing big - in infrastructure, aviation, factories - with bank money rather than their own cash. When promoters have very little skin in the game, they benefit from the upside of a business, but banks have to handle the downside. This is inequitable and unfair to the taxpayer who funds public sector banks.

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The public sector nature of banking creates perverse incentives for all parties. The situation is ripe for corruption for, if you have to get banks to lend to risky projects, you need to bribe either the politician who is their boss, or the banker himself. Either way, when things go wrong, you get a train wreck. Many promoters have had a ball inflating project costs so that even that tiny amount of capital they have to bring as their contribution to equity is essentially financed through excessive bank lending.

While all bankers plan for the fact that some loans will go bad (that is the essence of banking), private bankers - who are accountable to shareholders - have the freedom to cut their losses and get out when things go wrong. Public sector bankers are usually the ones left holding the baby. Consider: when Kingfisher was imploding, ICICI Bank sold its exposure while public sector banks are stuck with cleaning up the mess. What is the probability that political pressures were not at work in the way public sector banks showed endless patience with Vijay Mallya?

How are Arun Jaitley and Narendra Modi going to square the circle? They have to think privatisation.

I am not a doctrinaire privatiser myself. I believe that government should largely stay out of industries or sectors that are doing well, and should step in only when unavoidable. Government’s job is to make policy and create the right conditions for businesses to succeed. If they don’t, too bad. They should be given peaceful euthanasia with a good bankruptcy law like America’s Chapter 11. The public sector should play in areas where private capital is unwilling to go or is incapable of doing a good job. At the right time, if an industry or sector is capable of handling the challenges itself, government should make a profitable exit from public sector units. If government stays involved in too many businesses, it plays two conflicting roles - player and umpire. That can’t be good.

The time has come to apply this principle (umpire versus player) to public sector banking. India’s banking sector does not need a large public sector presence any more, even from the point of view of financial inclusion. Between business correspondents, unique ID-driven mobile banking, ATM technology and low-cost payment banks (to be licensed shortly), financial inclusion should be substantially achieved over the next five years.

The present crisis and scams in the public sector banking industry is a signal that the Modi government should start exiting the industry. It can be done carefully, in phases.

Here’s how.

The first step is to take banks out of the purview of the finance ministry’s direct administrative control and create a government holding company to house all bank shareholdings. The finance ministry in already thinking along these lines, but the holding company idea should not be seen as a solution. It should be seen as a stop-gap for creating an immediate arm’s length distance between policy maker (finance ministry and the RBI) and player. The holding company can be given a brief to improve public sector bank profitability in stage one, raise capital from the markets, and make these banks competitive.

The second step is to induct professional management in all banks. This is not to suggest that public sector banks don’t have professional managers, but too many of them are too compromised by the system and the lack of accountability to make a break with the past. A good idea would be to either induct CEOs from outside, or offer management contracts to groups of public sector or private managers with clearly defined financial and non-financial goals to meet in a defined timeframe. If they meet those goals, they can be given bonuses or shareholdings upto 5 percent.

The third step, once public sector banks start looking healthy, is to privatise by auctioning them to foreign banks or domestic private banks or new private players or even their employees through leveraged buyouts. Employees could get a 5-10 percent price discount over the top auction bids.

In the case of banks that have a chronic tendency for bad performance, they can be whittled down to “narrow banks” - or even reduced to mere payment banks after hiving off their assets (both loans and physical assets like branches) into a “bad bank” which can be sold to asset reconstruction firms. Excess employees should be given generous voluntary retirement packages or absorbed in other banks.

Sooner or later, Modi and Jaitley need to accept that the business of the government of India isn’t banking. Most public sector banks have to be privatised. They have no real purpose beyond being profitable. And that can be done by the private sector as well - with better accountability to shareholders.

Time to talk about the ‘P’ word aloud.