Context:

• The government’s recent decision to appraise the idea of privatising Public Sector Banks (PSB) and rising noises from the RBI for the same.

Introduction:

• The nationalisation of banks in 1969 was a watershed moment in the history of Indian banking.
• From July 19 that year, 14 private banks were nationalised and another six private banks were nationalised in 1980.
• It is certain that one cannot locate a similar transformational moment in the banking policy of any country at any point of time in history.
• At the time of Independence, India’s rural financial system was marked by the domination of landlords, traders and moneylenders.
• In 1951, if a rural household had an outstanding debt of ₹100, about ₹93 came from non-institutional sources.
• From the 1950s, there were sporadic efforts to expand the reach of the institutional sector, particularly in the rural areas.
• Despite these measures, the predominantly private banking system failed to meet the credit needs of the rural areas.

Class to Mass Banking:

• India’s banking policy after 1969 followed a multi-agency approach towards expanding the geographical spread and functional reach of the formal banking system. Some of the approaches that transformed class banking to mass banking are:

1. New branch licensing policy:

• First, as a part of a new branch licensing policy, banks were told that for every branch they opened in a metropolitan or port area, four new branches had to be opened in unbanked rural areas.
• As a result, the number of rural bank branches increased from 1,833 (in 1969) to 35,206 (in 1991).

2. Priority-Sector Lending

• As per this policy, all banks had to compulsorily set aside 40% of their net bank credit for agriculture, micro and small enterprises, housing, education and “weaker” sections.

3. Differential Interest Rate Scheme

• The differential interest rate scheme was introduced in 1974. Here, loans were provided at a low interest rate to the weakest among the weakest sections of the society.

4. Lead Bank scheme

• The Lead Bank scheme was introduced in the year 1969.
• Each district was assigned to one bank, where they acted as “pace-setters” in providing integrated banking facilities.

5. Regional Rural Banks (RRB)

• The Regional Rural Banks (RRB) were established in 1975 to enlarge the supply of institutional credit to the rural areas.

6. NABARD

• The National Bank for Agriculture and Rural Development (NABARD) was constituted in 1982 to regulate and supervise the functions of cooperative banks and RRBs.
• The outcomes of such a multi-agency approach were admirable. The share of institutional sources in the outstanding debt of rural households increased from just 16.9% in 1962 to 64% in 1992.

Growth Ignition:

• Few economists have argued that administered interest rates will cause “financial repression” in the economy.
• According to their view, if the government administers interest rates, the savings rate would decline, leading to a rationing of investment funds.
• But on the contrary, India’s nationalisation led to an impressive growth of financial intermediation.
• The share of bank deposits to GDP rose from 13% in 1969 to 38% in 1991.
• The gross savings rate rose from 12.8% in 1969 to 21.7% in 1990.
• The share of advances to GDP rose from 10% in 1969 to 25% in 1991.
• The gross investment rate rose from 13.9% in 1969 to 24.1% in 1990.
• Nationalisation also demonstrated the utility of monetary policy in furthering redistributionist goals.

Breaking the Barrier:

• Many of the mainstream economists have argued that banks cannot be used to right “historical wrongs”.
• On the other hand, India’s nationalisation has proved that monetary policy, banks and interest rates can be effectively used to take banks to rural areas, backward regions and under-served sectors, furthering redistributionist goals in an economy.

Post-Liberalisation Scenario:

• Strangely, arguments in favour of financial liberalisation after 1991 were based on the theory of financial repression.
• The Narasimhan Committee of 1991 recommended that monetary policy should be divorced from redistributionist goals.
• Instead, banks should be free to practise commercial modes of operation, with profitability as the primary goal.
• Taking the cue, the Reserve Bank of India allowed banks to open and close branches as they desired.
• Priority sector guidelines were diluted.
• Banks were allowed to lend to activities that were remotely connected with agriculture or to big corporates in agri-business, yet classify them as agricultural loans.
• Interest rate regulations on priority sector advances were also removed.
• The outcomes were immediately visible as more than 900 rural bank branches closed down across the country.
• The rate of growth of agricultural credit fell sharply from around 7% per annum in the 1980s to about 2% per annum in the 1990s.
• This retreat of public banks wreaked havoc on the rural financial market.
• Between 1991 and 2002, the share of institutional sources in the total outstanding debt of rural households fell from 64% to 57.1%.
• The space vacated by institutional sources was promptly occupied by moneylenders and other non-institutional sources again.

TO and FRO Approach:

• The government and the RBI probably saw the danger coming.
• In 2004, a policy to double the flow of agricultural credit within three years was announced. Only public banks could make this happen.
• So, in 2005, the RBI quietly brought in a new branch authorisation policy.
• Permission for new branches began to be given only if the RBI was satisfied that the banks concerned had a plan to adequately serve underbanked areas and ensure actual credit flow to agriculture.
• By 2011, the RBI further tightened this procedure. It was mandated that at least 25% of new branches were to be compulsorily located in unbanked centres.
• As a result, the number of rural bank branches rose from 30,646 in 2005, to 33,967 in 2011 and 48,536 in 2015.
• The annual growth rate of real agricultural credit rose from about 2% in the 1990s to about 18% between 2001 and 2015.
• Much of this new provision of agricultural credit did not go to farmers; it largely went to big agri-business firms and corporate houses located in urban and metropolitan centres — but recorded in the bank books as “agricultural credit”.
• For this reason, the share of institutional credit in the debt outstanding of rural households in 2013 stood at 56%, still lower than the levels of 1991 and 2002.

Role of Public Banks:

• In achieving the high growth of credit provision, the expansion of public bank branches is very pivotal.
• After 2005, public banks also played a central role in furthering the financial inclusion agendas of successive governments.
• Between 2010 and 2016, the key responsibility of opening no-frills accounts for the unbanked poor fell upon public banks.
• Data show that more than 90% of the new no-frills accounts were opened in public banks. Most of these accounts lie dormant or inactive, but it is unmistakeable that the fulfilling of the goal required the decisive presence and intervention of public banks.
• The same public banks were also India’s vanguard during the global financial crisis of 2007 when most markets in the developed world, dominated by private banks, collapsed.

Non-supportive role of Government:

• Despite a such a stellar track record of public sector banks, the macroeconomic policy framework of successive governments has hardly been supportive of a banking structure dominated by public banks.
• In times of slow growth, the excess liquidity in banks was seen as a substitute for counter-cyclical fiscal policy.
• Successive governments, scared of higher fiscal deficits, encouraged public banks to lend more for retail and personal loans, high-risk infrastructural sectors and vehicle loans.
• Here, banks funded by short-term deposit liabilities were taking on exposures that involved long-term risks, often not backed by due diligence.
• Unsurprisingly, many loans turned sour. Consequently, banks are in crisis with rising non-performing assets.
• If public banks are in dire straits today, it is because, with the closure of development banking in the country.
• They have been called upon to finance investments by the private sector in capital-intensive industry and infrastructure (such as steel and power generation and distribution, and transportation and communication).
• With those projects performing badly, the PSBs are being maligned so as to build a case to use them as instruments to write off the large loans on which big private sector operators have defaulted.

Way Ahead:

• The fear of fiscal deficits is also scaring the government away from recapitalising banks.
• The solution put forward is a perverse one: privatisation. The goose that lays golden eggs is being killed.
• The exact strategy of government is to separate the healthy parts of public banks and sell them to private banks so that the latter can grow and the former can shrink.
• There is no need to create a bad bank to absorb the bad assets of the public banks.
• The surgical action of separating the healthy and unhealthy part of the public bank concerned, leaves behind a bad bank.
• But nor is there any need to dilute shareholding in the public banks to mobilise resources to write off loss assets.
• The money obtained from the sale of the healthy parts would, it is hoped, be adequate to finance the write-offs.
• Thus, the NPA problem would move towards resolution and the goal of expanding private banking would also be achieved.