The roadmap for real banking reforms

The mindless consolidation of public sector banks is also not reform. (Reuters)

Bengaluru: The announcement of the merger of ten banks into four large banks has been touted over the past three weeks as a banking sector reform, based on the recommendations of the Narasimham Committee report (1991). The Narasimham Committee recommendations were forward looking and are still relevant. But if we examine the recommendations to see which of these have been effectively implemented, a pattern emerges.

There are two ways in which the State could look at the banking sector. On the one hand, there is a public purpose to be achieved. On the other, there is profitability. If we are unable to prioritise the purpose, the path we take will always look half-hearted and confused. If the objectives of the State are clear, there would be clarity on the instrumentality that is to be used.

We have argued in an article in Mint that the nationalization of banks in 1969 and again in 1980 achieved a larger public purpose. The same is applicable to the setting up of Development Financial Institutions in the 1950 and 60s and the establishment of Regional Rural Banks in 1975. This approach looked at banking (and financial services) as a public service, structured within the commercial frame. The concerns were largely pertaining to institutional access to services – particularly, credit to the poor and for public investments required to boost economic development. It did not really matter if these institutions made losses. They would be recapitalized once in a while to keep them going.

The nationalization of banks bridged the rural-urban divide to an extent by accelerating the opening up of branches in unbanked areas. The RRBs bridged the regional divide by taking a decentralized approach and setting up institutional access in regions other than southern and western India which were well banked. DFIs helped the industrial sector to develop roots. Nationalization of banks gave the comfort of sovereign backing to the banks (remember there was no Basel norms then) and it was possible for the banking sector to grow fast, without being bogged down by profit maximization considerations. The takeover of banking by the state gave it scale and spread.

The control of banking also helped in portfolio allocation to sectors that were underserved – agriculture and tiny, micro and small enterprises. This allocation was done through directed credit and administered interest rates which was a pure public purpose initiative and not a commercial decision.

Economic reforms

From 1991, there was a fundamental change in the way these institutions were seen as the government’s policy moved to become more market facing (while not giving up the public purpose agenda). The banks and the DFIs were redefined as market facing institutions. The reforms suggested by the Narasimham Committee were to make them completely market facing, seen purely through the prism of commercial viability.

If we look at the history of reform from 1991 onward, we find that all those reform measures that are market facing but do not have a public purpose implication have been implemented. However, the State has kept the banks under operational control because it continues to use them for implementing its public purpose activities. It is instructive to look at the Narasimham recommendations, which fell under three broad heads, in some detail.

Structural recommendations:

Autonomy for DFIs and banks; Boards to be made autonomous; CMDs to have a fixed tenure; Officers to be recruited autonomously with pay structures defined by the respective bank boards. An end to the duality of control, with regulatory control exercised only through the RBI and no government intervention, irrespective of ownership.

Have 3-4 national banks including the SBI, 8-10 universal banks, and a slew of local banks with regional footprint and each commercial bank will also need to have a rural bank as a subsidiary

These recommendations were never implemented in the spirit that they were made and in the sequence that it was supposed to be done. While the state was ambivalent about ownership and shedding its share, it was (and is) not fully convinced in letting go off operational control because it continues to serve a public purpose (like the opening of Jan Dhan Accounts).

The reform idea of autonomy, independence, and consolidation (in that order) was to signal that if there were any public purpose requirements, they had to be achieved through a non-discriminatory regulatory intervention that was ownership neutral. Autonomy would allow these institutions to strategize and hopefully consolidate based on synergies and value creation. The state has lost the spirit of these recommendations completely.

The committee also identified the reason for continued erosion in profitability of state-owned banks was due to their public purpose initiatives in the form of (a) directed investments and (b) directed credit. It suggested that the State should refrain from these.

These recommendations were implemented at a structural level, but sporadically the State continues to issue directions at the operational level. Targets for loans for the agricultural sector and Mudra are examples, which go beyond priority sector portfolio allocation targets. Under the UPA regime too, there was an initiative to double agricultural credit in three years.

Prudential recommendations:

The committee suggested that Statutory Liquidity Ratio (SLR) should be seen as a prudential requirement and not as an instrument for financing the exchequer and Cash Reserve Ratio (CRR) should be a monetary policy instrument and not a secondary expansion tool of the State.

The public purpose of deficit financing through banks was removed with the abolition of automatic re-monetisation and the passing of the Fiscal Responsibility and Budgetary Management (FRBM) Act. Therefore, SLR and CRR became prudential requirements without any implication for the State’s budgetary management. Other prudential suggestions, from capital adequacy to improving accounting standards, were also implemented by and large, perhaps because there was no significant implication on public purpose.

Operational recommendations:

The abolition of branch licencing; deregulation of interest rates; special tribunals for the recovery of non-performing assets (NPA); and the promotion of Asset Reconstruction Companies (ARC)

The branch licencing norms were indeed abolished. When it was seen that adequate branches were not being opened in rural areas, it was changed, but was done in a way which encouraged a level playing field for all banks by including the private sector banks. Interest rates were fully deregulated except for agriculture, where a perceived public purpose was being served. The other recommendations on NPAs were implemented, first through the SARFESI Act and then later through the IBC Code. ARCs were also set up.

Priority sector lending was to be redefined and restricted to 10% (as against 40%) of the bank credit. The credit was also to be directed only to small and marginal farmers and tiny, micro and small enterprises.

This was serving a larger public purpose, but was not implemented. However, since this is applicable irrespective of ownership, it should not be seen as reform measure in public sector banking per se.

The above instances illustrate that the state is unwilling to let go off operational control, especially when the pretext is a larger public purpose. The interventions over the past two decades have often come via the operational route rather than as policy or regulatory measures. At the same time, the state believes that since the vehicles used for these interventions are commercial organisations, they ought to be subjected to the market discipline of profitability and valuation. Herein lies the dichotomy: they are commercial structures but carry a load of non-viable public purposes objectives.

Mindless consolidation

In this context, consolidating banks and calling it “reforms” is a joke. The spirit of the reforms would be met if these institutions are completely made market facing. The intervention of the state for its public purpose objective should be through the policy and regulatory instrumentality and must be ownership neutral.

In the case of RRBs, they continue to serve a larger public purpose. Their balance sheet would need periodic recapitalization and has to be dealt with on the basis of the merits of the public purpose they are addressing. The approach of consolidation of RRBs and listing them while continuing to hold on to public purpose objectives is a mindless exercise. The State would never let go of the public (and non-viable) functions that these banks perform. The State hopes that as the picture becomes bigger, the warts will disappear. No, they won’t.

The mindless consolidation of public sector banks is also not reform. It just destroys the enterprise value, as we have seen in the market response to the merger announcements. The decision to merge should have been a market facing decision made through a process of discovery of synergies, brand potential, physical outreach, technology platforms, human resources, and unique strengths that mutually reinforce value creation. This is a professional exercise to be made autonomously. But now they are being made by people in administration who neither have the time nor the expertise to engage with value discovery and being implemented without much choice. Instead of solving a problem, this makes the problem bigger. Reform is based on one key word: “autonomy”.

The approach to reform, and the sequencing of reform, have been very well laid out in the recommendations of the PJ Nayak Committee. However, the state picks and chooses clauses without trying to understand the spirit in which the recommendations were made. Here is a way forward to think afresh on reforming India’s baking system.

A roadmap to reform

The opening up of banking to the private sector – both in the case of universal banks and niche banks – was a fundamental market facing reform. Continue to keep the licencing on tap.

Public sector banks should continue to serve a public purpose, but only through regulatory interventions that are ownership neutral. All regulatory control should be via RBI and the respective bank boards, not via the Ministry, arbitrary circulars or government fiat.

Repeal the Bank Nationalisation Act (PJ Nayak Committee recommendation); bring them under the Companies Act; apply fit-and-proper norms as applied to private sector banks. In the interim, there could also be an “autonomous” Banks Boards Bureau. But the faster it is abolished after it has served a temporary purpose, the better. The representation of the government on the board may be restricted to one member (Narasimham recommendation), representing the investment concern of the State. This ideally should be an expert from the investment community and not an officer of a government department.

Facilitate further consolidation based purely on value creation. If banks do not want to consolidate, let them be.

Let the board decide performance indicators for the Chief Executive. The public purpose performance indicators mandated by a policy and regulatory regime would be embedded in the performance indicators defined by the respective boards.

Remove all interest subsidies and subventions, including for agriculture.

Continue branch licencing norms for new branches in unbanked rural locations; continue priority sector norms for small and marginal farmers as well as tiny and micro enterprises, with stringent penalties for any shortfall.

Continue to support Regional Rural Banks through recapitalization. Do not make them market facing.

Set up back-stopping arrangements like specialised refinance/assurance institutions for infrastructure, education, agriculture and housing if they are not expected to be profitable and need continued state support because of their public purpose.

Do not dilute any norms for niche banks – the co-operative banks, small finance banks or payment banks were set up with a public purpose in mind and let them serve the purpose. Ensure that niche bank licences are not a back-door entry into a universal bank licence.

Even if public sector banks were to undertake public functions, try and ring-fence them into specialised subsidiaries and extend recapitalization support.

If the state is able to nuance its objectives, its actions will be effective. What is the measure of success or failure of reform? Here are two tests: The Delhi based Field General Managers of the banks must spend 90% of their time in customer interaction and banking and not with officials of the government. The frequency of the visits undertaken by the senior management of public sector banks to Jeevan Deep building in Delhi that hosts the officials of the Ministry of Finance falls to the same level of frequency as visits by private sector banking executives. If we pass these two tests, our public banks would have become truly autonomous and we would have real reform.