A vision for banking Shankar Acharya, Dec 5, 2001, 10.

30pm IST more than three decades have passed since indira gandhi nationalised the banks. with the benefit of hindsight and painful experience we can safely conclude that the decision was a major error in economic policy, with lasting adverse consequences. unfortunately, a witches' brew of stale ideology, vested interests and fear of the unknown has stood in the way of a necessary policy reversal. but the costs of the status quo are mounting daily. we need a vision for the future. the banking sector has not been devoid of reform. the first half of the nineties saw significant reform efforts, including: phasing out of almost all interest rate controls, major reductions in reserve requirements of slr and crr, abolition of quantitative, firm-specific credit controls, phasing in of internationally recognised prudential norms for capital adequacy, income recognition and asset classification, some dilution of 100 per cent government ownership of public sector banks (psbs), licensing of new private sector banks and more branches of foreign banks, strengthening of the supervisory framework for banking and the establishment of legal and operational structures for debt recovery tribunals to speed resolution of loan recoveries. these were all necessary and important reforms. but they did not tackle adequately the structural problems of public sector banking. even in the year 2000 gross non-performing assets (npas) of psbs as a proportion of commercial advances were very high at 14 per cent, compared to only 4 per cent for the new private sector banks and 7 per cent for foreign banks. net of provisioning, npas of psbs were higher than 7 per cent compared to under 3 per cent for the other two categories. by international standards, this ratio should be less than 2 per cent. psbs also suffer in comparison with the other two categories according to obvious performance yardsticks such as profitability and expense (especially wage-bill) ratios. psbs also drink frequently at the budget trough to shore up their inadequate and (sometimes) declining capital, thus compounding our grave problem of high fiscal deficits. this is especially true of a (growing) set of weak psbs. the slow pace of reform in the financial sector is captured by a friend's observation, while commenting on the changes visibly wrought between 1991 and 2001: " if you look at the range of products available in shops (or crowding our roads!), there has been a huge improvement in variety and technology. but in the financial sector, it is still the same old sbi, the same old idbi and the same old uti which dominate!" so where do we go from here? most importantly, we must recognise that a psb-dominated banking system (with over 80per cent of bank deposits in psbs) is simply not conducive to efficiency, innovation, fiscal prudence, investment and growth in our modern, increasingly integrated economic world. the rest of the world has

understood and acted on this premise. we need to do so also. this is not just an ideological fad. the need is grounded in the harsh realities of experience. the psb framework does not foster efficiency, innovation, risk-taking and commercial orientation. bank managements lack freedom in matters of recruitment, promotions and remuneration. they cannot redeploy labour easily, let alone retrench surplus staff. loss-making branches cannot be closed. customer service is weak. accountability is often of the wrong kind. the list is well-known. nor are psbs immune from scams and scandals. and it is very, very difficult for a government to allow a psb to fail, however strong the financial and economic case for closure. more than a year ago the government proposed amendments in banking laws to allow government equity in nationalised banks to be reduced to 33 per cent. but the case was made on the grounds of fiscal stringency to meet the capital needs of growing banks and a commitment was made to retain their "public sector character". surely the time has come to be frank. most of the problems of psbs are inextricably associated with government ownership and control. we don't need banks with minority government ownership and mainly "public sector character". we need psbs to be transformed into efficient, private sector banks. of course, they should be professionally managed, accountable to responsible, broad-based shareholders and a sound regulatory framework in a competitive environment. but let's be clear; we need to privatise our psbs for the same kind of reasons that underpin the government's privatisation programme in other sectors. so what's my vision for indian banking five years hence? ideally, the deposit ratios will have reversed, with 80 per cent in private banks and 20 per cent in psbs. there may be a strong, professionally managed private bank. the sbi is still likely to be there as a professionally managed public sector bank with good private sector characteristics of profitability, flexibility and technological strength. some of the other psbs would have undergone privatisation. a few may have been acquired by global banks with global reach. the weak psbs, which could not be sold, would have been closed(with protection to small depositors) or converted into "narrow" banks only allowed to buy government securities. other existing private banks would continue, merge into new entities or fail according to their performance in the market place. from today's perspective all this may seem like a pipe dream (to some it may be a nightmare!). but consider the alternative. if we continue our current course of hesitant banking reforms, financial stress will likely increase, the frequency of bailouts will probably rise putting a weak fisc under even greater pressure, the system's capacity to mobilise and intermediate financial flows will fall, harming both the level and productivity of investment and growth will suffer. the transition to a largely private sector banking system will be far from painless. but at least it holds out the promise of a rising curve of efficiency, confidence and growth. surely it's time to close the book on indira gandhi's mistake? ( the author is a professor at

icrier on leave from his previous assignment as chief economic adviser, ministry of finance. the views expressed are strictly personal.)