Public
ownership of banks, besides preventing periodic economic crises, can
subordinate the profit motive to social objectives and fashion a
system of inclusive finance, argues C.P.
Chandrasekhar.
5th
December 08 - C.P Chandrasekhar, Frontline
In
a reversal of its recently held position, the Congress party has
declared that publicly owned banks are one of India’s strengths and
that the nationalisation of banks was one of the party’s important
achievements. This has, as expected, upset those who have supported
the party’s two-decade long flirtation with financial
liberalisation, which included an as yet unfinished drive to
privatise public sector banks.
The declaration was
first made by Congress president Sonia Gandhi at the Hindustan Times
Leadership Summit. She argued that while the ongoing “economic
upheaval” could “grievously affect the most vulnerable sections
of our society”, her party had partially insulated India’s poor
from becoming “victims of the unchecked greed of bankers and
businessmen”.
Elaborating, she
said: “Let me take you back to Indira Gandhi’s bank
nationalisation of 40 years ago. Every passing day bears out the
wisdom of that decision. Public sector financial institutions have
given our economy the stability and resilience we are now witnessing
in the face of the economic slowdown.”
Coming from the
Congress party chief at election time, this could be dismissed as
mere rhetoric that is unlikely to influence policy. After all, the
United Progressive Alliance chairperson had noted in the same speech
that, the response to the economic slowdown resulting from the crisis
should not be a return to the era of controls.
But the cynics were
surprised when just days after Sonia Gandhi made her remarks, Finance
Minister P. Chidambaram took the cue from his leader and extolled the
virtues of a nationalised banking sector. Speaking at a function
organised as part of the M. Ct. M. Chidambaram Chettyar centenary
celebrations, he emphasised that India’s public sector banks were
strong pillars in the world’s banking industry.
This was because,
unlike the chief executives of private banks in the United States,
public sector bank managers did not violate regulations in search of
profits. For a Minister who has been pushing for the dilution of
banking regulations, the privatisation of public banks, and the
relaxation of the cap on voting rights of shareholders in banks, this
is indeed a reversal of position.
Three factors may
have contributed to this change of opinion. First, the evidence that
the managers of private banks pursuing profits had dropped all
diligence and made decisions that have threatened and are still
threatening the viability of leading banks in the developed
capitalist countries. These include banks that the advocates of
financial liberalisation and privatisation upheld as models of modern
banking.
Second, the
recognition that the only way in which the losses made by these banks
could be socialised and their viability ensured was for the
government to invest in their shares so as to recapitalise them.
Across the world, the response to the financial crisis has shifted
out of mere measures to inject liquidity into the system to backdoor
nationalisation of these banks so as to save them from bankruptcy and
to ensure that they keep lending.
Finally, the
evidence that on an average, the public sector banks in India have
weathered the financial storm much better than the private banks,
including some that had been celebrated as the post-liberalisation
icons of innovative banking.However, if the argument stops here, the
explicit or implicit defence of nationalisation and support for
public banking can only be partial and circumstantial.
What needs
recognition is a conceptual case for regulated, public banking that
emerges from the current and previous financial crises. It is now
widely recognised that the current crisis can be traced to forces
unleashed by the transformation of U.S. banking in the 1970s, when it
moved away from the “lend and hold” model in which the interest
margin – or the difference between interest paid on deposits and
the interest charged on loans – determined the profits of banks.
With interest rates
being controlled or regulated, this margin was small and implied that
the profitability of banking was low and below that of the rest of
the financial sector and even that of many non-financial industries.
In fact, during the inflationary 1970s, profitability sank even
further because savers moved out of bank deposits, returns on which
were regulated, to other kinds of financial instruments.
There was a good
reason why the banking system was thus regulated. As financial
intermediaries, banks accept deposits from the public at large,
including small savers. These deposits are insured against risk, are
liquid and can be withdrawn at will.
On the other hand,
the banks that pool these deposits provide medium or long-term
advances to borrowers who are risky targets, creating loan assets
that are relatively illiquid.
Given the risk
carried by these intermediaries, which are crucial to the real
economy, they had to be protected and the savings of small savers and
households secured through regulation, including regulation of
interest rates. A consequence was that banking was an island of low
profits, resulting in a conflict between this profit scenario and
private ownership.
It
was this conflict that led to the financial liberalisation of the
1970s and the 1980s in the developed countries, when processes
euphemistically referred to as financial innovation were adopted to
boost the profits of the banks.
As
a part of that, banks shifted to the “originate and distribute”
model in which they created credit assets not to hold them but to
pool them, securitise them and sell them to other investors,
transferring risk in the process. The banks’ own incomes now
depended not on net interest margins (after accounting for
intermediation costs) but on the fees and commissions they were paid
to serve as factories that produced financial assets for investors
with varying tastes for risk.
In the process,
banks migrated to a world where expected and realised returns were
much higher than earlier, resolving the conflict between private
ownership and lower relative profitability.
Unfortunately, that
transformation also generated all the elements that underlie the
current and previous crises. The number of bank failures in the U.S.
increased after the 1980s. From 1955 to 1981, U.S. banks averaged 5.3
failures a year, excluding banks that were protected by official
open-bank assistance.
On the other hand
from 1982 to 1990, the banks averaged 131.4 failures a year, or 25
times as many as from 1955 to 1981. During the four years ending
1990, banks averaged 187.3 failures a year. The most spectacular set
of failures was that associated with the “savings and loan crisis”,
which was precipitated by financial behaviour induced by
liberalisation.
Thus, there is a
fundamental contradiction in private enterprise capitalism. If the
banking sector is regulated, it cannot deliver the profits that are
considered adequate by private investors, who are given returns
elsewhere in the system. On the other hand, if regulations are
relaxed to facilitate the pursuit of profits, it will result in bank
fragility and “the poor become the victims of the unchecked greed
of bankers and businessmen”, as Sonia Gandhi noted. The only
solution, therefore, is the nationalisation of banking, or the core
of the financial system.
Such
nationalisation, which delivers a resilient banking system, yields
many favourable outcomes:
• It ensures the
information flow and access needed to pre-empt fragility by
substantially reducing any differences in the objectives and concerns
of bank managers, on the one hand, and bank supervisors and
regulators, on the other. This is a much better insurance against
bank failure than efforts to circumscribe their areas of operation,
which can be circumvented.
• It subordinates
the profit motive to social objectives and allows the system to
exploit the potential for cross subsidisation. As a result, credit
can be directed, despite higher costs, to targeted sectors and
disadvantaged sections of society at lower interest rates. This
permits the fashioning of a system of inclusive finance.
• It gives the
state influence over the process of financial intermediation and
allows the government to use the banking industry as a lever to
advance its development efforts. In particular, it allows for the
mobilisation of technical and scientific talent to deliver both
credit and technical support to agriculture and the small-scale
industrial sector.
This multifaceted
role for state-controlled banking allows the government to combine
policies aimed at preventing fragility and avoiding failure with
policies aimed at achieving broad-based and inclusive development.
Directed credit at
differential interest rates can lead to economic activity in chosen
sectors and regions and among chosen segments of the population. It
amounts to building a financial structure in anticipation of
real-sector activities, particularly in underdeveloped and
underbanked regions of a country.
The importance of
public ownership in realising these objectives cannot be
overstressed, since it requires subordinating the profit motive to
larger social goals, which would not be acceptable to a privately
owned and controlled banking system.
It hardly bears
emphasising that the achievements of India’s banks after
nationalisation have been remarkable. There was a substantial
increase in the geographical spread and functional reach of banking,
with nearly 62,000 bank branches in the country as of March 1991, of
which over 35,000 (or over 58 per cent) were in the rural areas.
There was a sharp
increase in the share of rural areas in aggregate deposits and
credit. In fact, a major achievement of the banking industry in the
1970s and the 1980s was a decisive shift in credit provision in
favour of the agricultural sector. From an extremely low level at the
time of bank nationalisation, agriculture’s share of credit rose to
a peak of about 18 per cent by the end of the 1980s.
In sum, public
ownership of banks, besides preventing the system from periodic
crises caused by the behaviour encouraged by the pursuit of private
profit, delivers many growth and welfare benefits.
It
is, therefore, gratifying that the combination of a financial crisis
and the pressures of electioneering have forced the government to
retract on its mindless advocacy of financial liberalisation and
recognise the benefits of public ownership. Whether this will
influence policy is, however, yet to be seen
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