Banks need a new social contract, not a debate around ownership

This article was published in the Economic Times on 5th Mar 2018

The PNB scam has ratcheted up the decibel levels of the debate around public sector banks (PSBs) in India. Unfortunately, the debate has been primarily focused around the ownership structure of the banks – publicly owned. It’s somewhat Kafka-esque – obsessing about black coffee after being beaten senseless by a couple of goons (Amerika, Franz Kafka’s first novel)! When the debate should be, as has been the case in the West for some time, about the role of banks per se.

In simple terms, are banks meant to be turbo-charged return on equity (ROE) machines, driving innovation, risk-taking and high returns for shareholders? Or should they be public utilities meant to provide low-risk plumbing for the real economy, not blowing up, and if they do, not presenting catastrophic outcomes for society? The question has always been around banking, but the question has become centre-of-plate since the financial crisis in 2008. At the core is the realisation that banking losses, irrespective of the nature of ownership, is a public liability.

Higher capital requirements under Basel III, higher compliance requirements, stripping off risky parts of banking from universal banks – there has been a global attempt towards making banks closer to utilities than ever before. In short, convert TBTF to “Too Boring To Fail” from “Too Big To Fail”. In many ways, the impact is visible – with ROEs of banks globally more resembling utilities (5-9%) than banking in the previous decade (15-20%).

Unfortunately, the debate in India gives this a near-complete miss. In some ways, the so-called “reforms” are looking to reverse the better characteristics of Indian banking.

To start with, the assumption of big being better. For many years now, the government has postulated that most PSBs are too small, and need to be merged into larger, “global sized” banks. While progress on this front has been slow, SBI did a mega merger of all its associate banks last year as part of the same strategy. It’s a strange hypothesis – smaller the bank, smaller would be its organic and systemic impact of failure. India is uniquely blessed in this regard – barring SBI and ICICI, most banks have single-digit market shares. It makes the system more resistant to systemic failures. But proposed “reforms” are looking to create a more vulnerable banking system by creating larger banks.

Second, while there is a welcome new process/law for bad loan resolution, there is still little work on addressing the core issues. Banking loans fall essentially under three categories – corporate finance, corporate and commercial loans and retail loans. In India, bulk of NPA issues have arisen on account of large project finance loans extended by PSBs. Earlier, the failure of Global Trust Bank was on account of large exposure to capital markets. There is a fundamental mismatch – between the riskappetite and tenor of the liability (deposits) and asset (loans) sides of the banks’ balance sheets here. Unfortunately, even as RBI (and the government) have tightened operational rules around lending, credit appraisal etc, there has not been any serious discussion around why commercial banks, funded by short-term retail deposits, should be giving out long-term project loans, or write guarantees secured by capital market exposures.

Third, India has gone slow on capital buffers. Even as GOI embarks on a massive recapitalisation plan for PSBs, amounting to over ₹2 lakh crore, there is little conversation on how and why Indian banks would continue to have weaker equity capital buffers compared to the rest of the world.

Corporate finance activities should be done from an entity outside of a commercial bank. They should not be allowed to be funded by retail deposits. Two, banks that raise bulk of their deposits from retail customers should be restricted to writing retail and selective corporate & commercial loans. Balance corporate/commercial loans should be funded out of deposits raised from wholesale (corporations, institutions etc) customers. Three, capital requirements on banks should be set high, so high that they simply cannot fail. Once done, there would be little probability of taxpayer bailouts, irrespective of ownership.

The debate on ownership, especially privatisation, is sexier than a debate around the social contract of banking. As it was for Karl Rossman in Amerika, it was more interesting to discuss the role of black coffee in his station in life, rather than the tragedy of his journey from Europe to New York. But banking might require a touch more attention than Kafka!