India's public sector banks are suffering from high non-performing assets and poor capitalisation. The government is considering privatisation as a way to revamp these lenders – starting with IDBI Bank – but is this the right solution? Rekha Gupta Menon investigates.

India’s public sector banks (PSBs), which form the bedrock of the country's banking industry, are facing rough weather. Slow economic growth, policy gaps and stalled infrastructure projects have led to an alarming build-up of stressed assets over the past three years, and this is hitting bank profitability and capital positions, more so for PSBs than their private sector counterparts.

According to estimates by the country’s central bank, Reserve Bank of India (RBI), while PSBs' share of total banking assets remained nearly the same at more than 70% between financial years 2012-13 and 2014-15, their share of total banking profits dropped from nearly 55% to 42.1% in the same period. Private sector banks, in fact, surpassed PSBs in the share of overall banking sector profits in financial year 2014-15. This trend has continued in financial year 2015-16, with a rising number of PSBs reporting losses.

The ongoing turmoil has served to highlight long-standing structural defects of PSBs. With the Indian government holding a majority stake in PSBs, low functional autonomy and undue government interference are constant challenges. Sub-optimal board appointees, ineffective bank boards and weak governance are other constraints that put the banks at a significant disadvantage to their private sector counterparts.

Industry experts have long advocated privatisation as a key measure to enable PSBs to overcome these challenges. In the late 1990s, the Committee on Banking Sector Reforms, headed by ex-RBI governor M Narasimham, recommended a reduction of government equity in PSBs to 33%. More recently, in 2014, the Committee to Review Governance of Boards of Banks in India, headed by PJ Nayak, a former chairman and CEO of Axis Bank, recommended that the government transfer its stake in PSBs to a bank investment company (BIC) and thereafter consider reducing its equity to less than 50%.

Trade union opposition

Suggestions to reduce government stakes in PSBs face tough opposition, especially from banking trade unions and left-of-centre political parties. “Privatisation is not the solution. Private sector banks have seen many failures too,” says CH Venkatachalam, general secretary of the All India Bank Employees Association (AIBEA), the country’s largest bank union, which represents about 500,000 bank employees. He gives the example of Global Trust Bank, a private sector bank launched in the mid-1990s along with ICICI Bank and HDFC Bank. The bank collapsed under the weight of non-performing assets (NPAs), and in 2004 was merged with Oriental Bank of Commerce, currently the seventh largest public sector bank in India.

A country such as India with high developmental requirements will suffer because of privatisation, says Mr Venkatachalam, since profitability is the main driver for private sector banks, unlike PSBs, where social responsibility is key. “In the absence of public sector banks, who will give educational or agricultural loans? Who will give infrastructure loans?” he asks.

Arun Tiwari, chairman and managing director of Union Bank of India, says both public and private sector banks have strengths and weaknesses. “Competition from private sector banks has helped in expanding choice for customers and raising service standards across the spectrum. On the other hand, we have also found, to our discomfort, aggressive mis-selling and financial duping of unsuspecting customers,” he says, adding that it would be wise for both private and public sector banks to learn from each other’s experiences to build a more robust and democratic financial system in the country.

Privatisation – good or bad?

As such, Mr Tiwari says there is no conclusive evidence on ownership structure as a determinant of efficiency of a bank. “If we give a glance at banks around [India], there are some banks in the public sector doing well compared with many of the banks in the private sector," he says. "If one takes a dynamic view, over a fairly long period, a wide variety emerges in performance across the spectrum, notwithstanding differences in ownership structure. We have indeed been witness to many cases wherein private sector banks were merged or taken over with or by banks from [the] public sector to help salvage depositors and [the] financial system as a whole.”

Calls for PSB privatisation are misplaced because the ownership structure does not impact performance, according to professor TT Ram Mohan, who teaches finance and economics at the Indian Institute of Management Ahmedabad (IIMA), and regularly consults with the banking sector. “The popular assumption that the public sector character of banks is an obstacle to performance does not stand up to scrutiny,” he says. “Studies show that public and private bank performances over the long term have tended to converge. It is only in the past three to four years that there is a notable performance difference. This is because of external factors out of banks’ control.”

The stress in the banking sector is emanating primarily from loan slippages in infrastructure and allied sectors caused by external demands such as the economic downturn and delays in government clearances. Since PSBs fund the majority of infrastructure projects, they are the ones that have borne the brunt of burgeoning NPAs. It is important to note that private sector banks with exposure to the infrastructure sector, such as ICICI Bank and Axis Bank, have not remained unscathed. ICICI Bank, for instance, reported a 32.7% increase in NPAs between the third and fourth quarter of financial year 2015-16. In the same period, it reported a 76% drop in net profits to Rs7.02bn ($1.05bn), its lowest in a decade.

There is a trade-off between efficiency and stability, according to Mr Ram Mohan. “In the 2008 global banking crisis, many so-called efficient banks went under. Unlike most countries, the Indian banking sector has remained remarkably steady over the past two decades. India’s record shows that PSBs have been a force for stability,” he says. He concedes, however, that there is merit in strengthening PSB boards and their governance structure.

Revamping PSBs

In August 2015, the Indian government came up with a seven-step ‘Indradhanush’ PSB revamp plan. It includes guidelines for top management appointments; setting up an autonomous banks board bureau (BBB); capitalisation; strengthening risk control measures; ensuring no government interference; creating a framework for key performance indicators; and improving human resources management practices. This plan is already in motion and the BBB came into being in April 2016, replacing the existing appointments board. The BBB is responsible for appointing CEOs, senior management and independent directors at PSBs. Headed by the country’s former comptroller and auditor general, the BBB’s mandate also includes helping PSBs develop growth strategies and capital raising plans.

The BBB should have a positive impact, according to Arundhati Bhattacharya, chair of the country’s largest PSB, State Bank of India (SBI). She observes that a strong board can provide good guidance, saying: “Under the oversight of a strong board, banks can react to situations in a nimble manner. The key issue is an enablement to be able to attract the right kind of talent, as well as the ability to source appropriate infrastructure and technology.” 

Abizer Diwanji, leader for financial services at EY India, says that more than privatisation, PSBs will benefit through process and governance improvements that the BBB will set into place by professionalising aspects such as talent acquisition, board appointments and compensation.

Keeping distance

Although the Indian government has not made any specific announcements, industry experts envisage the BBB will finally merge into a BIC, along the lines of the Nayak committee recommendations. The BIC would help the government to distance itself from several bank governance functions it presently discharges, while still maintaining control.

“Creating a BIC is a practical solution rather than going for outright privatisation,” says Joydeep Sengupta, director at consulting firm McKinsey’s Asia-Pacific banking practice. He refers to the BIC as an “intermediate approach” where the government moves from being a bank operator to a bank investor functioning as an institutional investor.

Several countries have set up similar intermediate investment companies to hold equity in banks. The Singapore government, for instance, controls DBS through Temasek; the UK government controls RBS and Lloyds Bank through the UK Financial Investments; and the government of Belgium controls Fortis and Dexia through SPFI-FPIM, a holding company. Mr Sengupta says: “The BIC will enable the government to be the dominant shareholder. At the same time it will discourage direct intervention and help relieve the constraints that public sector banks face today.”

While most industry experts support the BIC approach, they unanimously agree that setting up the BIC is going to take time and effort. This is not only because of potential trade union opposition, but also because the investment company can be set up only after significant legislative amendments. For the BIC to become operational, the Bank Nationalisation Acts of 1970 and 1980, under which most PSBs operate, as well as the SBI Act and SBI (Subsidiary Banks) Act that controls SBI and its associate banks, would have to be repealed. All banks would need to be incorporated under the Companies Act, 2013, which is regarded as a superior law for board governance that can provide BIC with the requisite autonomy, professionalism and empowerment.

Privatising IDBI

In his budget speech this February, Indian finance minister Arun Jaitley announced the government’s plan to reduce its stake in IDBI Bank to below 50%. This plan did not require any legislative change since IDBI Bank is the only PSB that was incorporated under the Companies Act. While the markets reacted favourably to the news, banking trade unions called for a strike.

“We have told the government that rather than privatisation they should take appropriate steps to improve the functioning of PSBs. Government interference should stop. There should be strict enforcement of regulation and accountability. Additionally, the government should take criminal action against wilful defaulters to recover NPAs,” says Mr Venkatachalam of the AIBEA.

IDBI Bank's shareholder breakdown, pre-privatisation new

Kishor Kharat, CEO and managing director of IDBI Bank, downplays talk of privatisation and refers to the stake dilution as a step in the transformation journey for the bank. IDBI Bank was formed in the mid-2000s through mergers between parent Industrial Development Bank of India, a leading development finance institution, and United Western Bank, an ailing private sector bank. “IDBI Bank is at a point of inflection. It took 12 years for the bank to move from a development financial institution ethos to a commercial bank ethos. We now have an aggressive business plan for the next three years. But we need capital for this transformation, which can be achieved through government stake dilution,” he says.

Mr Kharat points out that apart from the government’s near-74% stake, state-backed insurance group Life Insurance Corporation of India (LIC) holds a 14.37% stake in IDBI Bank. “Even if the government brings down its stake, when combined with the LIC stake, it will remain the majority shareholder. The discussions with various strategic investors including multilateral agencies are in progress. There is no private player,” he says. Local media reports suggest that the government is in talks with interested strategic partners to buy up IDBI Bank’s stake, such as the World Bank’s International Finance Corporation, US private equity firm TPG Capital and UK development finance institution CDC Group.

Reducing government stakes

The biggest benefit of reducing the government’s stake, according to Mr Kharat, is the availability of additional capital. “The government does support with capital required by the banking industry. However, for the projected growth of IDBI Bank, we need additional capital that can be raised by diluting the government stake. Even if the government stake is reduced from 74% to over 51%, a huge burden will be lifted,” he says. Other benefits include improvements in corporate governance through the entry of new strategic investors in the board, and talent acquisition. 

In March 2016, ratings agency Crisil downgraded its ratings on the securities of eight PSBs, one of which was IDBI Bank. In a press release, Crisil said its actions were “driven by the expectation that the asset quality problems being faced by PSBs will remain acute and continue through most of the next fiscal year. The resultant impact on profitability and capitalisation can further dent the credit profiles over the medium term.”

R Gandhi, deputy governor at RBI, points out that the main challenge faced in diluting the government stake in IDBI Bank will be “timing and market pricing”. “The pace of disinvestment will depend on market receptivity,” he says. He does not foresee employee-related issues in this exercise because IDBI Bank is a new generation bank. “IDBI Bank is a different genie than other PSBs. The age profile of employees is much younger, which is a natural advantage. They would be willing to take this challenge. Their pay structure is also very different from other PSBs, hence it should be easy enough to manage,” he adds.

The Indian government might have set in motion a few measures to alter the ownership structure of PSBs, but it is going to be a long-drawn affair. It is also widely accepted that privatisation on its own is no panacea. Hence, it is critical that PSBs focus on improving corporate governance and strengthening their performance. Any strategy, be it consolidation or privatisation, will only be effective once this is achieved.

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