Not easy to privatise India's public sector banks

The government announced in its last budget its intention to privatise two public sector banks (PSBs) in the coming financial year.

This is more easily said than done. I argue in my column in BS today, Bank privatisation as an experiment, that the task involves huge challenges. If privatisation doesn't work out, it will pose serious risks to financial stability. So, the government must proceed cautiously. Let it treat the privatisation of two banks as an experiment and watch the outcomes over three or four years. Only if things work out, should we think of privatising more PSBs- this should not be turned into an ideological issue. The government must hope that privatisation doesn't mean more Yes Banks that will have to be thrown into the lap of SBI for rehabilitation.

As the BS article is behind a pay wall, here is the full text:

 

Bank privatisation as an experiment 

The government must test the efficacy of privatising two banks first before going the whole hog

 

Say this for the proposed move to privatise two public sector banks (PSBs) in the coming financial year: It’s preferable to the course proposed by the P J Nayak Committee on bank governance (2014). 

 The committee had proposed a bank holding company, run by professionals, to which shares of PSBs would be transferred. The proposal was always a non-starter. Handing over 60 per cent of the banking system to a group of “independent” professionals, however eminent, is unthinkable. If the government wishes to give autonomy to PSBs, it can do so today. And if it doesn’t, creating a bank holding company run by professionals won’t make any difference.

 Getting PSBs to match private sector compensation by letting the government’s shareholding drop below 50 per cent is also fanciful. No government enterprise can have the sort of inegalitarian pay structure that one finds in the private sector. The public sector could certainly do with better incentives. But these can never match those of the private sector. 

 The public sector and the private sector are two distinct business models. One offers high pay, the prospect of rapid promotion and considerable work pressure. The other offers job security, enormous challenges, quality housing and a lower cash component. It’s a choice of two different lifestyles. Picking elements from the two models and combining them will take us nowhere. 

 You want fewer PSBs? Better to go the whole hog and privatise the ones you think you don’t need. Then, the government is no longer accountable to parliament for the performance of the bank.  Starting off with a couple of banks is a good idea. Provided it’s understood that this is strictly an experiment. We have to carefully watch governance and performance at privatised banks over at least three or four years before we think of privatising any more PSBs. 

Even privatising just two PSBs is a huge challenge. The big question is: Whom can the government sell the PSBs to? The larger private banks in India have a significant pan-Indian presence. They are unlikely to want to take over a large PSB with a very different culture and legacy issues. Handing over PSBs to Indian corporations is inadvisable and politically contentious. 

 Foreign banks have been retrenching their Indian operations in recent years, especially in respect of retail operations. Assuming there are some with an appetite for the Indian market, how many will be keen to set up a subsidiary subject to the Reserve Bank of India’s (RBI’s) stringent norms for the same? That leaves foreign institutional investors. The Nayak Committee had held up Axis Bank as a role model for dropping government shareholding below 50 per cent. But the case is by no means self-evident.

 Let us ignore the issues Axis Bank faces today. Whatever success the bank has had did not arise simply from the government’s shareholding dropping below 50 per cent. Axis Bank started off as UTI Bank, a government entity.  Even after the government’s shareholding dropped below 50 per cent, LIC and other government entities held significant stakes in it and they still do. It wasn’t that the government decided to hand over matters overnight to dispersed institutional shareholders. 

Moreover, UTI Bank was quite small in size when the government opted to privatise it. Almost any PSB that the government wishes to privatise today would be bigger in size than UTI Bank at the time of privatisation. 

 We need investors who will actively monitor the privatised bank. Private equity firms fit the bill. The RBI’s Internal Working Group to review bank ownership had recommended that non-promoter shareholding be enhanced to 15 per cent. This was, no doubt, intended to facilitate a significant stake for investors such as private equity firms. It must be seen as part of the prelude to bank privatisation.

 A couple of other measures must be seen in the same light. The decision to set up an Asset Reconstruction Company (ARC), sponsored by PSBs and private banks, is one such. The proposal had not taken off earlier because it wasn’t clear why a government-owned ARC that aggregates good loans would do a better job of restructuring them than a consortium of banks. Nor is that any clearer now. The principal motivation for an ARC at this point appears to be to get some bad loans off the books of banks that are to be privatised. That way, they will be more attractive to private suitors. So will allowing private banks to do government business, another measure recently announced. 

 Nevertheless, several challenges remain. The impact on depositors of a drop in government shareholding below 50 per cent is one. Dealing with the large tracts of land PSBs sit on is another.  These include a bank’s headquarters, regional offices, training centres and accommodation for employees. Private investors may not want to pay for all of these, they will be interested mainly in the branch network. As in the case of Air India, it may make sense to move some of the land and building to a Special Purpose Vehicle. 

 Private investors will want to rationalise branches and reduce employee strength. According to media reports, moves are afoot to transfer some of the employees of PSBs to be privatised to other banks. With a chunk of bad loans off the books, a reduced employee strength and land transferred to an SPV, valuation of a bank may become easier. But it does not ensure that it will be free from controversy. Most PSBs are trading way below their book values today. Getting a reasonable valuation will require a competitive auction process with a large number of bidders. Yet, for the reasons mentioned above, the set of potential bidders is quite small. 

 Overcoming resistance from bank unions is another challenge. Bank unions have already called for a two-day strike. The government must take steps to avoid the sort of confrontation it is facing with farmers. One, it must convince bank unions that the government wishes to strengthen the PSBs that are not privatised, not dismantle the public sector. It may like to assure unions that PSBs’ share will not fall below, say, 50 per cent in the next three years. Two, it must assure unions that that employee interests in privatised banks will be safeguarded.  

Three, the government must offer to use the capital raised from the sale of two PSBs to bolster capital at some of the remaining PSBs. Increasing capital in some PSBs will improve their valuations and boost lending as well. Re-investing privatisation proceeds in the remaining PSBs will help the government produce positive outcomes in quick time. It is the surest way to win hearts and minds on bank privatisation. 

 

(ttrammohan28@gmail.com)

 

Privatisation myths and realities

There is no economic topic, perhaps, on which misconceptions are as pervasive as privatisation.

Let me address a few:

i. Private firms are always more efficient that state-owned enterprises (SOEs): Not really. Comparative performance depends on a number of things- regulated versus competitive industries, developed countries versus less developed countries, 100 per cent SOEs versus listed SOEs. In regulated industries, many studies show no difference in performance. In advanced countries with developed capital markets and good governance structures, private firms do better but not  so much in less developed countries. Again, many of the comparisons where SOEs fare poorly relate to 100 per cent government-owned entities. Where the government exposes SOEs to competition and subjects them to market discipline through listing on exchanges, SOEs fare much better. In India, many SOEs showed an improvement in performance consequent to listing.

ii. Under-performing SOEs should be sold off to private parties, then performance will improve: Not true. A change in ownership by itself may not translate into improvement in performance. The valuation of the SOE has a bearing on the outcome. Let us say a listed SOE is sold below its correct value at a time when stock market prices are generally depressed. The new owner has merely to wait for the market to recover to meet his return threshold. He does not have to exert in order to improve firm efficiency. The method of sale or the design of privatisation is thus critical to the outcomes that follow.

iii. Improved performance of SOEs post privatisation shows private ownership is superior: Wrong. SOE  performance often suffers for want of capital- governments facing fiscal constraints are unable to provide the capital needed for modernisation and growth. When the firm is transferred to a private owner, capital comes in and performance improves. Managerial competence is not the factor. Then, privatisation of SOEs is often a long drawn-out process. During the period, managers have little incentive to perform. Once sold, managerial focus returns and performance improves. It is not the change of ownership per se that has contributed. Many SOEs shed flab and streamline operations in order to make themselves attractive to private owners. The results show up over time - and are incorrectly ascribed to a change in ownership.

iv. Auctions automatically result in the sale to the highest bidder and hence ensure improvement in performance post privatisation: Well, no. Much depends on whether the auction is efficient. This requires numerous conditions to be satisfied: multiple bidders, the absence of collusion, opening up to domestic as well as international bidders, etc. In practice, these conditions are rarely satisfied. The auction is not efficient and the firm does not necessarily past into the hands of the most deserving private party. As a result, improvement in firm efficiency may not happen nor will the government have succeeded in maximising revenues through privatisation.

v. What applies to non-financial firms applies to banks as well: Wrong. One of the important considerations in selling off SOEs is that they will then cease to make demands on government capital. In banking, however, the government remains responsible for rescuing all but the smallest of banks. The considerations that apply to privatisation of non-financial firms do not, therefore, apply to banks. Bank privatisation requires to be handled with a great deal more caution.

More in an essay on privatisation I have penned for The India Forum.