The Importance of Public Banking System to India

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.