Context

Former RBI governor D. Subbarao raised the question of whether India needs public sector banks at all in this day and age.

Reasons for privatization

• The country’s financial sector is now wide enough and deep enough to take care of financial intermediation without state support. 

• Even after the bank nationalization of 1969, the state dominance of the sector has kept competition levels low.

• There was unnecessary micro-management by RBI, resulting in poor lending decisions and market distortions.

Problem with interest rate benchmarking

• Right now, banks are largely expected to do as they are told. Last RBI’s directive to commercial banks to link their loan rates with its repo rate or other external benchmarks need not be issued in truly free markets. 

• Competition for loan customers would not let a bank keep its lending rates higher. Rivalry for deposits and other funds would mean a bank pays as much as it could afford to.

• To find the best way to gain an edge in a competitive market, banks would turn efficient.

• In India, state lenders are under little pressure to do this. Tough the entry of private banks has upped service standards and induced some changes, the sector is saddled with non-performing loans, inefficiencies and heavy costs. 

• High state-controlled rates of interest on small saving schemes attract a big chunk of people’s savings, leaving lenders short of money to lend and paying too much for deposits.

Cause for privatization

The sector’s health requires banks to assess and price risks properly. For this, bankers need to act diligently in the interest of profit-seeking shareholders. This would be better enabled by privatization. 

Challenges with privatization

• State’s exit could result in foreign equity control of banks and even a loss of sovereignty.

• Since large banks would be “too big to fail”, the government would still need to bail them out in case they approach bankruptcy. This would involve public funds and amount to the socialization of losses.

• Close regulation would still be needed.

Way ahead

With all the challenges above, the state could argue it needs to retain ownership control as well. Immediately, at least the appointment of public sector bank chiefs must be freed of state control.