Banking Sector Reforms

Privatisation of Banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 3-Privatisation of banks in India and debate around it

The article highlights the different aspects that need to be considered while contemplating the idea of privatisation of public banks.

Opposite trends in India and the US

  • While the United States epitomises the private banking model, a nationwide public banking movement is coming into vogue.
  • In contrast, India seems to be quickly warming to the idea of bank privatisation.

Public or the private?

  • The development view sees government presence in the banking sector as a means to overcome market failures in the early stages of economic development.
  • The government-owned banks can improve welfare by allocating scarce capital to socially productive uses.
  • The stellar success of Indian PSBs in implementing the PMJDY while missing the mark on creating high-quality credit highlights a critical divide between the asset and the liability side of a bank.
  • Banks provide two functions at a fundamental level: Payments and deposit-taking on the liability side and credit creation on the asset side.
  • The payment services function, a hallmark of financial inclusion, is similar to a utility business — banks can provide this service, a public good, at a low cost universally.
  • The lending side, in contrast, is all about the optimal allocation of resources through better credit evaluation and monitoring of borrowers.
  • Private banks are more likely to have the right set of incentives and expertise in doing so.
  • It comes as no surprise that the PSBs in India are better at providing the public good functions, whereas private banks seem better suited for credit allocation.
  • However, the political view argues that vested interests can influence the lending apparatus to achieve political goals.
  • This results in distortion of credit allocation and reduce allocative efficiency in government-owned banking systems.

Reasons for privatisation of banks

  • Evidences shows that government ownership in the banking sector leads to lower levels of financial development and growth
  • This led to waves of banking sector privatisations that swept emerging markets in the 1990s.
  • Cross-country evidence suggests that bank privatisations improved both bank efficiency and profitability.

How public banks performed in India

  • Public sector Banks (PSBs) dominate Indian banking, controlling over 60 per cent of banking assets.
  • The private-credit to GDP ratio, a key measure of credit flow, stands at 50 per cent, much lower than international benchmarks — in China it is150 and in South Korea it is 150 per cent.
  • India’s Gross NPA ratio was 8.2 per cent in March 2020, with striking differences across PSBs (10.3 per cent) and private banks (5.5 per cent).
  • The end result is much lower PSB profitability compared to private banks.
  • The rationale for privatisation stems from these considerations.

Way forward

  • The optimal mix of the banking system across public and private boils down to what you need out of your banking system.
  • When the wedge between social and private benefits is large, as with financial inclusion, there is a strong case for public banks.
  •  At this stage, inefficiency in capital allocation seems to be a bigger issue for the Indian banking sector, whereas, in the US, the debate is centred around the public goods aspects of banking.

Consider the question “What are the factors India needs to consider as it reverses the course of history by privatising the public banks?”

Conclusion

At this stage, inefficiency in capital allocation seems to be a bigger issue for the Indian banking sector, whereas, in the US, the debate is centred around the public goods aspects of banking.

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