Indian banking - Reform by death

 B S :Arvind Subramanian  March 7, 2014 

Since the government cannot privatise public sector banks, 

the central bank should force it to let the bad ones fail

The past is never dead. It's not even past," noted the American novelist

 William Faulkner. Arguably, the two most egregious economic policy 

mistakes of the past that continue to haunt India were the licensing of 

Indian industry during the Nehru years and the nationalisation of private

 banks byIndira Gandhi in 1969. These actions had one common disastrous 

feature: penalising and expropriating the Indianprivate sector.

 Other policies that turned out to have adverse consequences were 

different in principle. They at least purported to help the private sector

 (such as the imposition of trade barriers to protect industry from

 foreign competition) or fill in for it (such as the creation of the public sector).

Restrictive industrial licensing policies have been almost completely reversed, 

although their consequences still linger (most notably in the weak

 performance of Indian manufacturing). But bank nationalisation

 endures as a millstone around the Indian economy, a grim reminder

 and legacy of Indira Gandhi's policies.

Undoing this legacy may well turn out to be one of the most critical tasks 

for the Reserve Bank of India's (RBI's) current governor, Raghuram Rajan.

 The problem is so intractable and so embedded in Indian politics that 

only he can, and can afford to, take on the challenge.

On the face of it, that task has begun. The RBI will soon be awarding new 

banking licences to allow for a greater role for private sector banks. 

But this may not be enough. Consider why.

Since 1991, an overarching principle for eliminating inefficiency in

 vast parts of the economy has been this: to promote competition

 via private sector entry rather than change ownership throughprivatisation.

 This approach had some intrinsic merit - after all, Russia went from

 communism to gangsterism because it sold public assets cheaply 

to a few oligarchs.

More importantly, the entry-favouring approach had the virtue of political 

expediency. Privatising public sector companies would have encountered 

significant opposition from their managers as well as from strong unions. 

Allowing private sector companies to enter the market without touching

 the public sector incumbents bypassed some of these costs and allowed 

reform to proceed by stealth. The logic and hope, of course, were that a 

vibrant private sector would grow rapidly while the public sector would 

shrink, at least in relative terms.

And the strategy broadly worked. Yes, Air India is still a mess and a public

 burden, but the Indian aviation and telecommunication sectors of today

 are mercifully - and unrecognisably - different from what they were 

20 years ago, with enormous benefits for the Indian economy. Public 

sector companies now account for a small share of the overall size of

 these sectors.

This entry-favouring strategy was tried in banking too. Since the early 

1990s, a number of new banking licences were given to the private sector -

 think of ICICI, HDFC, Axis Bank, Kotak Mahindra, Yes Bank, and so on. 

Yet, the share of public sector banks in total banking (measured as a 

share of assets or deposits) has stubbornly persisted around 75 per cent. 

And the reason is simple. The private banks have grown, but the public 

sector banks have grown too because India's politicians have used them 

as a way to channel money to private sector operators - often very

 influential ones. The credit boom of the 2000s, which is now manifesting

 itself in rising non-performing loans, emanated mostly in the public sector. 

Vijay Mallya did not borrow from private banks; he was enabled into 

borrowing from, and undermining, the public ones. So, going forward

 the fact of more private banks is no guarantee of reducing the role of 

public sector banks.

This will be especially true if the new banks are encumbered with regulations 

such as priority sector lending, which restricts their ability to grow. So, as 

new banking licences are awarded, the aim should be to tilt the playing field 

as much as possible against the public sector incumbents in whose favour 

the playing field is already hugely tilted by way of unlimited financial support

 from the public exchequer.

One possibility relates to foreign banks. It is true that the world over - and

 especially in the United States - regulators are forcing foreign banks to 

create subsidiaries in host countries so that they will have more capital to

 cushion against crises. But in India the benefits of subsidiarisation must 

be weighed against the costs of deterring foreign bank entry, which might

 have other benefits such as being able to effectively compete and

 out-compete public sector banks.

What can be done more directly to reduce the role of public sector banks? 

Because such banks are important levers of political control and influence,

and because bank unions remain powerful, explicit privatisation seems off 

the table. But there is an indirect way of privatising them, or at least

 beginning the process of privatisation, which the RBI should seize. And

 the opportunities could present themselves soon.

As growth declines and exposes the fragility of some of the public bank

s in the form of rising non-performing loans, the RBI should be brutal in

 its assessment of them, erring on the side of declaring some banks as 

unviable commercial institutions. The government will want to bail out 

the failing banks through fresh capital infusions.

But here is where the RBI should stand firm, urging the government to

 let them go, on the grounds that a fragile economy can afford neither

 the fiscal costs of bailouts nor the efficiency costs of bad banks continuing 

to be prolonged on life support. The worse the economy, the more the 

bargaining chips Dr Rajan will have. And he should use them to resolve

 the bad public banks, in part by transferring their good parts to the 

private sector.

This strategy may sound difficult to implement. Indeed, it will be. But it is

 the only way forward. The past two decades have taught us that private

 banks cannot really grow unless and until public sector banks are shrunk. 

That shrinking may have to be achieved by allowing the bad public sector 

banks to fail because politics will never allow good public sector banks to 

be privatised. It was famously said that in science progress is made one 

funeral at a time. Unfortunately, that may be the only realistic way of

 reforming Indian banking too.