Friday, April 01, 2016

Why we need the public sector in banking

Most people make the case for public sector banks (PSBs) on grounds of meeting large social need- inclusion, priority sector, regional development, etc.

There is, however, a more solid case to be made for PSBs. This is that PSBs are a force for stability. Private banking systems are inherently unstable, as a recent book, which I have reviewed in EPW, makes clear. The author, Adair Turner, former head of UK's FSA, argues that private banks have every incentive to expand credit as much as possible. An excess of credit leads on to boom and the inevitable bust. Given the low levels of capital required by banks, an economic bust means a banking crisis.

There's really no way to avoid a banking crisis in today's private banking systems without restricting their ability to create credit. The extreme solution was proposed years back by the Chicago School which argued for 100% reserves in banking- all bank deposits should be invested only in safe securities and banks should exist primarily for the purpose of making payments. In other words, a zero credit banking system is the only safe system. Turner thinks this is too extreme a solution and instead proposes limits on banks' ability to create credit.

I would argue that an alternative is to have a public sector-dominated banking system. PSBs do not have the same incentives to create credit recklessly. That is because executive  pay is not linked to credit creation and the profit it generates. Secondly, unanticipated risks and losses and arise don't translate into bank failure and a banking crisis. Although depositors in India are insured only upto Rs 1 lakh of the deposits they hold, the public believes that the government stands behind their deposits in full. In other words, the sort of unlimited guarantee on bank deposits that came into vogue in Europe after the financial crisis of 2007 is something that is implicit in a PSB-dominated system.

This explains why we have not any failures in banking or a crisis despite the huge increase in NPAs in recent months. Even in the weaker PSBs, depositors are not queuing up to ask for their money. Contrast this with the situation in a large private sector bank in 2009 when the mere whiff of trouble almost caused a run on the bank.

Banks in India will have to fund projects whose risks are not always clear- as we have seen in infrastructure in recent years. Banks can't steer clear of these risks because there's nobody else to fund them- we don't have long-term financial institutions and bond markets to do the job. However, when these risks materialise, that should not translate into a banking crisis. These conditions can be met only with  a PSB-dominated banking system.

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