Context: Of-late there is a lot of buzz about privatization of public sector banks. There have been several reports in the media about the future of central banks. Social media too is abuzz with several forwards doing the rounds asking people to be careful of their deposits. Such fears are mostly unfounded. Though there have been reports about possible privatization of banks in India, there have been no concrete announcements, apart from an indication from finance minister Nirmala Sitharaman in May. In a privatization scenario, the government will always retain a portion of the bank’s stake and as such will remain a shareholder. Whenever bulk withdrawal of deposits takes place, the government as a shareholder will step in to adequately capitalize the bank. Meanwhile, a RBI board member has said Public sector banks should not be privatised given the country's developmental needs but the government can look at reducing its shareholding to 26 per cent by selling a larger portion of its stake.
What is the trilemma about?
The sovereign (government) and the regulator (RBI) face a trilemma: It is clear that it is not possible to:

• Have dominance of government banks (public sector banks) in the banking sector;
• Retain independent regulation; and
• Adhere to public debt-gross domestic product (GDP) targets.
• The government along with RBI cannot hope to achieve all three points at the same time.

Only two out of the three can be achieved:

• Predominant public sector and independent regulation by RBI.
• Predominant public sector and adherence to debt to GDP targets.
• Let’s say the government wants the public sector banks (PSBs) to dominate the banking system and at the same time ensure that the public debt doesn’t go up.

What will happen in such a circumstance?

• In this scenario, the Reserve Bank will have to compromise on independent regulation.
• To dominate the banking system, PSBs will have to increase lending at a fast pace.
• This will lead to accumulation of bad loans or loans that haven’t been repaid for 90 days or more.
• Given that the recoveries of bad loans are minimal, the government, as the owner, will have to invest more money into the PSBs to keep them going.
• If the government puts more money into the PSBs, its expenditure will go up. It will have to borrow more money and the public debt to GDP ratio will substantially rise.

How can public debt to GDP ratio be saved from rising?

• The central bank will have to dilute some regulations to help the PSBs in not recognizing bad loans.
• In such a case, the government need not invest in the PSBs immediately. PSBs will have a greater market share and the public debt to GDP ratio will not rise right away. However, the central bank will have to dilute banking regulations.

What is the issue with RBI diluting norms?

• When RBI dilutes regulations, banks end up kicking the bad loans can down the road.
• This postponement leads to a bigger problem, which hits the banks, not immediately, but a few years later.
• This is precisely how PSBs accumulated peak bad loans of Rs 8.96 trillion, as of March 2018.
• The government then has to recapitalize the banks in the years to come. In the process, it pushes the public debt to GDP ratio up. This is one situation that the government has been trying hard to avoid.

Arguments for reducing government dominance on Public Sector Banks (PSBs):

• The basic argument that has been making has its roots in the discourse on banking reform and reducing dominant state ownership and control over the banks.
• There is an assumption that state-owned banks have a sovereign guarantee and, therefore, safe from the depositors’ perspective. But sovereign ownership also creates a sense of performance complacence.
• The punishment by the stock market for non-performance is blunt but it does not ostensibly harm the dominant shareholder.
• It is the minority shareholder who suffers at the first instance and then (if the insulation of the sovereign is removed) the saver.
• However, if there is a large overlap between savers and tax payers then they are paying the price for saving themselves at one end even as the cost of finance for the economy does not go down.
• The cost of non-performing assets and administrative overheads ultimately has to be recovered from the profits — a reason that indicates that interest rate cuts do not get transmitted.

Conclusion: Eventual way out for RBI and government:

• The decline in the share of government banks in the banking sector should not be resisted.
• Current trends broadly suggest that the banking sector is increasingly privatized, by stealth, much like the telecom sector.
• In the last decade, the share of PSBs in overall lending has dropped sharply from 75.1% to 57.5% at present.
• As PSBs keep losing share, they will cause fewer headaches for the government and the central bank in the decades to come.
• While India does face this trilemma as proposed by the former governor, unchecked privatization may not be the solution.
• A balanced approach is needed where the resolution process of financial failure of private banks needs to be evolved. These norms must address how to secure depositor interests.

Rationale of Privatization of PSBs

• Bulk of NPAs: The banking system is overburdened with the non-performing assets (NPAs) and the majority of which lies in the public sector banks.
• Issue of Dual Control: PSBs are dually controlled by RBI (under the RBI Act, 1934) and Finance Ministry (under the Banking Regulation Act, 1949)
• Thus, RBI does not have all the powers over PSBs that it has over private sector banks, such as the power to revoke a banking licence, merge a bank, shut down a bank, or penalize the board of directors.
• Lack of Autonomy: Public sector bank boards are still not adequately professionalized, as the government still decides board appointments (as the Bank Bureau board is not fully functional). This creates an issue of politicization and interference in the normal functioning of Banks.
• Difference of Incentives: Private and public sector banks are driven by different incentives. 
• For example, Private banks are profit-driven whereas the business of PSBs is disrupted by governments schemes like farm loan waivers etc.
• Also, in the private sector, the shareholders’ effective control over banks may explain the absence of large-scale frauds like in public sector banks such as the Punjab National Bank episode.

Issues Related to Privatization of Banks

• Issue of Governance: The key issue of Indian banking is a lack of adequate governance which stretches across public and private ownership.
• In the case of PSBs, there is political interference while private banks are prone to malpractices in the wake of serving the interest of its promoters.
• The testimony that the problems of Indian banking transcend issues of ownership lies in the plight of YES Bank.
• Policy Issue: Restructuring schemes such as corporate debt restructuring, strategic debt restructuring and schemes for sustainable structuring of stressed assets, initiated by RBI, are the major reasons for delaying the recognition of bad loans, which are irrespective of ownership (public as well as private) of the banks.
• Failure of Regulation: As RBI may not have similar control over PSBs as with respect to private banks, this does not explain why the RBI cannot hold the PSBs accountable for issues such as capital adequacy, fraud control or appropriate reporting of financial statements.
• RBI is well legislatively equipped to regulate banks under the RBI Act.

Road Ahead

• Improving Governance: In order to improve the governance and management of PSBs, there is a need to implement the recommendations of the PJ Nayak committee.
• De-Risking Banks: There is a need to follow prudential norms for lending and NPAs can be tackled through the establishment of the bad bank and speedy resolution of NPAs through Insolvency Bankruptcy Code.
• Corporatisation of PSBs: Rather than blind privatisation, PSBs can be made into a corporation like Life Insurance Corporation (LIC). While maintaining government ownership, this will give more autonomy to PSBs.