October 2017: Privatising PSU banks: Effective long term solution

The Finance Minister recently announced that the government plans to recapitalise the PSU banks to the tune of Rs 211,000 crore – of this, 135,000 crore will be funded by recapitalisation bonds and the balance through a mix of budgetary sources and market borrowings. Recapitalisation bonds are bonds issued to the PSU banks by the government in lieu of cash which they normally would have to pay for infusing capital into the PSU banks. This method of recapitalisation has been used before, in the 1990’s under similar circumstances when the PSU banks were saddled with large losses. The woes of the PSU banks have been a regular subject of our newsletters in the past and we would like to take this opportunity to discuss this further. As we have pointed out before, the Indian economy is unable to reach its full potential because PSU banks are unable to lend because of insufficiency of regulatory capital.

The Indian banking sector is dominated by the PSU banks which form 70% of total advances in the system. There are very few sectors of the economy which have been privatised for more than 20 years and the public sector continues to hold such dominance. Over the years the PSU banks have always had higher gross non-performing assets (NPAs) than the private sector. As on 31-Mar-17 the average PSU bank had gross NPAs of about 11.8% of their advances, while the average private sector bank had gross NPAs of 4.8%. There are a large number of reasons for this poor performance of the PSUs – some of them are legacy issues related to political interference, inability to hire the best talent due to restrictive government pay scales, lack of operational freedom and lack of incentives to control credit costs. Meanwhile some of the private sector banks have also had to report a larger NPA problem than previously reported as the RBI has become increasingly strict about NPA recognition. Yet, the problem is contained in the private sector and they are also better capitalised than the PSU banks.

Banking is a capital hungry business which is likely to grow faster than the rest of the economy and it is not advisable over the long term that the government continuously pump in capital into PSU banks which controls a dominant 70% of the total market, given its implication on the fiscal deficit. We think that the long term solution to this problem lies in reducing government stake in PSU banks below the 51% mark. This will take them out of their public sector character and has attendant benefits in the form of operational freedom and ability to attract appropriate talent. In order to ensure that the banking sector does not fall in the hands of foreigners as may be feared by some, the government can impose a 5 or 10% limit on the shares that people acting in concert can buy into the PSU banks. We believe that privatisation would be a more efficient way to deal with the ills of the banking sector.

Having said the above, we do note that the size of the recapitalisation is sufficiently large and addresses the capital needs of the PSU banks. Moreover, the government has announced that it would introduce reforms in PSU banks – we would watch out for these reforms and see how effective they are in ensuring that lending decisions in the future are more prudent. Meanwhile we retain our preference for those private sector banking and finance companies which have a history of controlling their credit costs better.