Privatization of Indian banks | The financial express


In 1969, the Indian government nationalized the country’s banking sector. The aim was to make financial services more inclusive and stimulate economic development by guiding the financial sector. This was in line with the post-independence strategy of occupying the “commanding heights” of the economy, but this approach was already showing signs of dysfunction at that time. The subsequent record was mixed at best, and economic reform consisted of gradually making room for private sector banks, while trying to strengthen public sector banks through structural reforms.

In an analysis that has already received considerable attention, eminent economists Poonam Gupta and Arvind Panagariya (GP) make a cautious and convincing case for a major effort to privatize India’s public sector banks. Currently, there are 12, but the State Bank of India (SBI) stands out for its size, importance and operational quality. Thus, GP suggests that SBI remain in the public sector, but strongly argues that the remaining 11 banks should be completely privatized.

The case for privatization rests on the relative track record of public and private sector banks over the past decades. Although there was considerable variation in the quality of performance within each category, on average, private sector banks perform much better than their public sector counterparts. Greater efficiency through privatization can improve the allocation of financial resources within the economy, promote financial sector growth, and support higher overall economic growth.

GP outlines a course of action which is to start with two strong public sector banks (already suggested by NITI Aayog) as a model, the rest to follow. Privatization would imply a complete divestment from the state, in order to avoid any shadow of discretionary interference after privatization. This makes sense if the benefits of privatization are to come from independent management and operational efficiency. This rationale also means that merging public sector banks is not a productive policy path. GP is relatively agnostic on the exact process, including the possibility of dispersed ownership as well as large strategic buyers. In particular, they argue that non-financial firms should be allowed to buy banks, with the issue of control of crony lending being addressed through appropriate regulation and enforcement. They note that technological innovation is already opening up banking and similar services to a range of non-financial businesses, including various technology companies.

Bank privatization will not be easy, but the time seems to have come. India’s economy certainly needs a more efficient financial sector if it is to grow at rates that will generate enough good jobs for its people. There are strong political barriers, due to the large number of people employed in public sector banks. Banking unions have already voiced their opposition and the government has already postponed parliamentary consideration of the legislative changes that would be needed to allow privatization to begin. It may seem easier to expand the banking sector by issuing new licenses to private sector banks. But that would prolong the pain and increase the costs of an inefficient banking sector.

As the political issues associated with privatization are digested, there is clearly a need for a strategic vision and analysis of what the Indian financial sector might look like in a decade. This involves thinking about the impacts of technology, the role of non-bank financial firms, the competitive structure of the industry, scale and other efficiency considerations and, most importantly, a new regulatory architecture. Regulations can be designed to manage risk, as well as to promote efficiency and inclusion. In some cases, the regulatory framework is adequate on paper, but monitoring and enforcement capabilities are far too limited. The RBI, currently struggling with near-term challenges related to inflation and exchange rate management, should invest heavily in improving its capacity in all aspects of its role as a financial regulator.

India needs a much better financial sector. Technological innovation opens up new possibilities for efficiency and inclusion. But finance involves a unique set of risks and challenges. Problems in the financial sector can spread like wildfire within the sector and bring down the whole economy. But underlying the GP’s proposals is a sense of confidence that India has the knowledge, experience and capacity to radically restructure its banking sector. There are clear technical arguments for continuing privatization, but the public sector needs to step up its management of the political economy of change, as well as its regulatory responsibilities after restructuring.

The argument for privatizing India’s public sector banks is ultimately an argument for economic development. When the government sets targets for the expansion of the country’s manufacturing sector, these targets will never be achieved without a better functioning banking sector. Indeed, the privatization of public sector banks can only be part of a strategy for financial sector reform and growth, if the industry, along with the rest of the economy, is able to thrive. Articulating this link will be part of the political challenge of this reform.

The author is Professor of Economics, University of California, Santa Cruz


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