Rajan's warning to govt: Stay away from PSU banks or you will destroy them

Raghuram Rajan, the economist-turned-central banker, made headlines early this week for his comments that the Narendra Modi government wouldn’t take in good humour.

Speaking at separate events in Mumbai, Rajan came down heavily on the practice of government using public sector banks as convenient channels to roll out its political agenda.

Implicitly referring to the Jan Dhan Yojana, Modi’s flagship financial inclusion scheme, Rajan said if the government gives a mandate to public sector banks to further its social sector agenda, the government itself should fund it to ensure financial viability for the entities.

“You can’t give a mandate and not fund it,” Rajan said. “After all public sector banks also have private shareholdings and are not any longer an extension of the government. They should be seen as independent entities.”

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Micromanagement

Rajan’s comments are highly critical and make immense sense for India’s state-run banks in the backdrop of the fact that their competency is being challenged by deep-pocketed rivals in the private and foreign sector. State-run banks, thus, have been losing out market share over years.

That is not surprising for these entities, which are remote controlled by the finance ministry, often get subjected to political intervention in their business divisions and, thus, rarely left to operate on their own.

Whether public sector banks should be independent from the government is a question being debated ever since the first set of the nationalised banks happened in 1969 when Indira Gandhi was the prime minister.

But the business decisions of state-run banks have remained under state-control of the finance ministry since then. Their independence has remained only on paper, despite having competent management teams and boards.

The finance ministry has been dictating on the business decisions of state-run banks, in the form of missives and diktats on issues ranging from pricing of loans, directed lending to certain segments such as agriculture and small industry units and selective restructuring of stressed loans.

“Unless the government completely stays away from the operations of state-run banks, professionalism cannot be brought in to their existence,” said a senior official at a global consultancy firm on condition of anonymity.

To be sure, micromanagement of public sector banks by the finance ministry doesn’t have a direct correlation with a particular political party in power at the Centre be it the Congress or BJP. During the UPA’s time too, instances of the finance ministry sending missives to state-run banks marked a significant increase.

There are several examples of the government’s direct intervention in the running of banks-be it using state-run banks to roll out the Rs 71,000 crore farm loan waiver of 2008, the current round of loan waivers in southern states being planned by regional political parties or influencing the management decisions on various aspects.

In 2012, the finance ministry wrote to banks ordering them to give their balance sheets to their respective audit committees, two days before the boards meet to finalise accounts. The demand was resisted by banks, which argued that the information is price sensitive and can’t be shared in advance.

On the other hand, private banks are aggressively competitive. They typically engage only in those business activities (except in the case of priority sector lending mandated by the RBI) that return good money to them.

This makes competition tougher for Sarkari banks and force them to do businessesthat probably never made sense for them and instead, only helped add to their bad loans. Of the Rs 2.5 lakh crore bad loans on the books of 40-listed Indian banks as of end June, over 90 percent came from state-run banks.

Burden of populism

Part of the reasons of high bad loans in public sector banks can be attributed to their lack of freedom to operate in a competitive manner. This aspect is most visible when it comes to serving the poor with banking access, known as financial inclusion.

Under the extant norms, all banks in India must set aside 40 percent of their loans to agriculture, exports and other economically weaker sections under the so-called priority sector guideline norms.

But beyond this, the burden of funding agriculture and government-sponsored schemes, in particular in the infrastructure sector, falls upon state-run banks, while private and foreign banks largely stay away from the risky lending.

State-run banks have been bearing the onus of meeting the agriculture credit target given to the banking system by the government, even when agriculture as a percentage of GDP has been falling over years.

Besides the loan waivers, the biggest impact on the state-run banks is likely to unfold from Jan Dhan Yojana, being implemented by the Modi government at bullet pace.

The scheme forces banks to open crores of zero balance accounts in serious dilution of KYC norms within a few months, offer free debit cards and insurance facility.

Even though bankers and the RBI had expressed reservations against the dangers of diluted KYC norms, the government went ahead with the plan. In the event of these accounts remaining inoperative or defaulting, the impact on banks will be severe.

Besides being the vehicle of rolling out the populist schemes for governments, state-run banks are also more susceptible to influences by politicians to lend to a particular company.

During the UPA-II, among the several cases of bad loan accounts was a construction company directly controlled by the daughter of a cabinet minister, to which banks had lent Rs 350 crore that had turned bad.

The way out

If state-run banks need to be made independent in true sense, the government must bring down holding pin state-run banks below 51% and thus privatise these entities.

A report tabled by a committee headed by P J Nayak, former Axis Bank chief, has already laid out a road map to strengthen the public sector banking system.

The prescriptions include empowering the boards of state-run banks through a three-stage transition process and bring down government stake in state-run banks below 50 percent-in other words, privatise the government banks.

The government cannot be in the business of banking, and should, instead focus on only governance, for which it has the public mandate. The policymaker and the market player being the same party-the government-create conflict of interest.

Professionalism can only be brought in by treating the government banks as private organisations and gradually reducing their dependency on the government to meet their capital needs.

Those banks, which are unable to raise capital and manage on its own, should cease to exist or merge with another bank, if there is synergy.

According to rating agency Fitch, Indian banks will require more than $200 billion in fresh capital as they prepare for the full implementation of Basel III capital requirements by March 2019.

A capital constrained government may find it difficult to meet this demand unless it is willing to bring down majority stake in public sector banks. The government owns more than 70 percent stake in 12 public sector banks and over 80 percent in six banks.