Explained: The move to privatise banks

The Budget proposes to privatise two PSU banks this financial year. Why was the need felt, 51 years after nationalisation of govt-owned banks? A look at the banking sector’s concerns, and moves to address them.

The banking landscape in India is set to change with the government’s decision to privatise two public sector banks. Coming after 51 years of nationalisation of government-owned banks in 1969, the move will give the private sector a key role in the banking sector.

Why the proposal?

The Union Budget has announced the privatisation of two public sector banks (in addition to IDBI Bank) and one general insurance company in the upcoming fiscal. It also announced a strategic sale/disinvestment policy for four strategic sectors — including banking, insurance and financial services — in which it will have a “bare minimum presence”.

Years of capital injections and governance reforms have not been able to improve the financial position of in public sector banks significantly. Many of them have higher levels of stressed assets than private banks, and also lag the latter on profitability, market capitalisation and dividend payment record. The government front-loaded Rs 70,000 crore into government-run banks in September 2019, Rs 80,000 crore in in FY18, and Rs 1.06 lakh crore in FY19 through recapitalisation bonds. In 2019, the government merged ten PSU banks into four.

Privatisation of two public sector banks will set the ball rolling for a long-term project that envisages only a handful of state-owned banks, with the rest either consolidated with strong banks or privatised. This will free up the government, the majority owner, from continuing to provide equity support to the banks year after year. Through a series of moves over the last few years, the government is now left with 12 state-owned banks, from 28 earlier.

The two banks that will now be privatised will be selected through a process in which NITI Aayog will make recommendations, which will be considered by a core group of secretaries on disinvestment and then the Alternative Mechanism (or Group of Ministers).

What are the issues plaguing PSU banks?

After a series of mergers and equity injections by the government, the performance of public sector banks has shown improvement over the last couple of years. However, compared with private banks, they continue to have high non-performing assets (NPAs) and stressed assets although this has started declining.

After the Covid-related regulatory relaxations are lifted, banks are expected to report higher NPAs and loan losses. As per the RBI’s recent Financial Stability Report, gross NPA ratio of all commercial banks may increase from 7.5% in September 2020 to 13.5% by September 2021 under the baseline scenario (from 9.7% to 16.2% for public sector banks; from 4.6% to 7.9% for private banks).

This would mean the government would again need to inject equity into weak public sector banks. The government is trying to strengthen the strong banks and also minimise their numbers through privatisation to reduce its burden of support.

Why were private banks nationalised in the first place?

Then Prime Minister Indira Gandhi, who was also Finance Minister, decided to nationalise the 14 largest private banks on July 19, 1969. The idea was to align the banking sector with the socialistic approach of the then government. State Bank of India had been nationalised in 1955 itself, and the insurance sector in 1956.

Various governments in the last 20 years were for and against privatisation of PSU banks. In 2015, the government had suggested privatisation but the then RBI Governor did not favour the idea. For over 50 years, successive governments have chosen not to bother beyond a point. As former RBI Governor Dr Y V Reddy once said, nationalisation was a political decision, so privatisation too will have to be one. Seen in this context, privatisation of two banks and the indication of carrying it further is a major reform signalling a changing political approach. These moves, along with setting up an asset reconstruction company entirely owned by banks, underline an approach of finding market-led solutions to challenges in the financial sector.

Are private banks doing better?

Private banks’ market share in loans has risen to 36% in 2020 from 21.26% in 2015, while public sector banks’ share has fallen to 59.8% from 74.28%. Competition heated up after the RBI allowed more private banks since the 1990s. They have expanded the market share through new products, technology, and better services, and also attracted better valuations in stock markets — HDFC Bank (set up in 1994) has a market capitalisation of Rs 8.80 lakh crore while SBI commands just Rs 3.50 lakh crore. India has 22 private banks and 10 small finance banks.

However, in the last couple of years, some questions have arisen over the performance of private banks, especially on governance issues. ICICI Bank MD and CEO Chanda Kochhar was sacked for allegedly extending dubious loans. Yes Bank CEO Rana Kapoor was not given extension by the RBI and now faces investigations by various agencies. Lakshmi Vilas Bank faced operational issues and was recently merged with DBS Bank of Singapore. Moreover, when the RBI ordered an asset quality review of banks in 2015, many private sector banks, including Yes Bank, were found under-reporting NPAs. Former Axis Bank MD Shikha Sharma too was denied an extension.

What has been the government and RBI stand on privatisation since 1969?

The UPA government of 2004-14 refrained from taking any decision on privatisation. Many committees had proposed bringing down the government stake in public banks below 51% — the Narasimham Committee proposed 33% and the P J Nayak Committee suggested below 50%. An RBI Working Group recently suggested the entry of business houses into the banking sector. The NDA government, in its second term, has been pushing for privatisation and reducing the number of PSU banks to five or six.

According to RBI’s History series, the number of commercial banks was brought down sharply from 566 in 1951 to 91 in 1967 in order to consolidate commercial banking, which was very fragile. By the mid-1960s, Indian banking had become far more viable than ever before. However, the expansion of branches was mostly in urban areas, and rural and semi-urban areas continued to go unserved, RBI History’s Volume 3 notes.

The big question is: will private banks repeat the mistakes of 1960s. There is widespread perception that the private sector then was not sufficiently aware of its larger social responsibilities and was more concerned with profit, which made private banks unwilling to diversify their loan portfolios as this would raise transaction costs and reduce profits.

Will more PSU banks be privatised in the coming years?

Currently, there are ten nationalised banks in addition to IDBI Bank and SBI. While the government is unlikely to touch the top three including SBI, smaller and middle-level banks are likely to be privatised. The Finance Minister did not disclose which two banks will be privatised this fiscal.

The initial plan of the government was to privatise four. Depending on the success with the first two, the government is likely to go for divestment in another two or three banks in the next financial year. PSU banks are under dual control, with the RBI supervising the banking operations and the Finance Ministry handling ownership issues.

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