Bank Privatisation by the Backdoor (epw)

The P J Nayak Committee on the governance of bank boards has proposed that the Bank Nationalisation Act and related legislation be repealed. It wants government shareholding in public sector banks to be transferred to a Bank Investment Committee that will be manned by professional bankers. The report assumes incorrectly that ownership determines board performance and that the quality of bank boards, in turn, determines bank performance. The key issues at the public sector banks, in fact, are those related to management.
T T Ram Mohan ( teaches at IIM Ahmedabad.
After some two decades of impres sive growth and improvement in financial performance, India’s public sector banks (PSBs) are under stress at the moment, thanks to a slowdown in growth and a rise in non-performing assets (NPAs). They need a significant amount of capital to sustain growth under the Basel 3 norms for capital adequacy.
The P J Nayak Committee on governance of bank boards in India, constituted by the Reserve Bank of India (RBI), has the standard remedy for all ills in the public sector: reduce government involvement and shareholding and eventually privatise. The committee’s remit was not limited to PSBs but the focus of the report is on these banks. The treatment of governance issues in private banks is rather superficial. This is, of course, not the first committee to advocate the privatisation route for PSBs. That achievement belongs to the Percy Mistry Committee report of 2007, of which little has been heard since.
The committee believes that the financial position is “fragile” (which is something of an exaggeration going by the average return on equity, even in the last three stressed years and not just the position at the end of 2013). PSBs, it says, lack a sense of direction and focus on issues of strategy and risk management. It believes that these problems have arisen because of poor governance. Governance needs to be strengthened. This can happen only if the government distances itself from governance functions and, ultimately, sheds its majority ownership.
The committee provides a detailed road map for reaching this destination:
(i) The Bank Nationalisation Act and the State Bank of India (SBI) Act must be repealed and all banks converted into companies under the Companies Act.
(ii) Government must transfer its holdings in banks to a Bank Investment Company (BIC). Responsibility for governance thus gets transferred to the BIC.
(iii) In Phase I, until the BIC becomes operational, a Bank Boards Bureau comprising senior bankers should advise on all appointments, including those of chairmen and executive directors.
(iv) In Phase II, when the BIC becomes operational, the governance functions will be exercised by the BIC.
(v) In Phase III, the BIC will transfer the governance functions to the respective bank boards. This could be accompanied by the BIC lowering its stake in PSBs below 50% so that PSBs are freed from constraints on pay and from the purview of the Central Vigilance Commission and the Right to Information Act.
(vi) Although the report does not explicitly recommend this, it hints at the possibility of government’s shareholding in the BIC itself falling below 50%. If this happens, it would amount to privatisation of the all PSBs.
In what follows, I first critique what I believe are key premises of the report. I will then go on to the important issues in the banking sector that require the government’s attention and how these might be addressed.
Premises of Report
The report rests on a number of premises. Let me take up these one by one.
The first is that government ownership renders PSB performance inferior to that of private banks: This contention is not supported by the empirical research on the subject. A number of studies have pointed to convergence in performance of public and private sector banks in the post-reform period. Bank performance in India has been, to a large extent, ownership neutral. (See, for instance, T T Ram Mohan, “Banks: Financing the future” in Ashima Goyal (ed.), The Oxford Handbook of the Indian Economy in the 21st Century, OUP, May 2014.)
The committee bases its contention on figures for a small period. The report has charts that cover bank performance in the most recent period 2005-13. These too show a trend towards convergence in the period 2005-07 and again in 2011. It is only in the extraordinary slowdown of the 2012 and 2013 that a sharp divergence arises. Some of this is temporary in nature. We can expect to see it reversed as economic growth improves in the next two to three years.
It is important also to realise what has caused divergence in performance in the stressed years. PSBs invested heavily in the infrastructure sectors that drove growth in the golden period of 2004-08. These very sectors have run into problems because of a host of issues, some of which are non-economic in nature.
Some of the best performing private banks have chosen to focus on working capital and retail finance and have ended up with rosy figures. In the very nature of things, PSBs cannot have such a narrow focus. It would be unwise to jump to conclusions about ownership from a comparison of numbers at a given point in time.
Naiveté about Professionals
The second premise is that the performance of banks has to do the quality of governance or the effectiveness of boards: PSB boards, the report says, are dysfunctional. But so are many private bank boards. Boards, in general, are dysfunctional. Some of the biggest failures in the financial crisis were the boards of the largest and most reputed banks in the West.
It is sheer naiveté to suppose, as the Nayak Committee does, that the mere induction of professionals will bring about a sea change in the functioning of PSBs. The Royal Bank of Scotland, the biggest banking failure in the history of the United Kingdom (UK), had all the professional expertise that any bank board could ask for – and yet this very board was a mute witness to reckless decisions taken by the management.
Public sector bankers will tell you that some of the best contributions to the board come from the RBI nominee on the board. Besides, it is not as if the government packs PSB boards entirely with incompetent persons or that PSB boards today lack professionals. The missing ingredient in PSBs today is lack of management depth and competence, a point we will come to a little later.
The third premise holds that board governance can improve only if government is distanced from the board: Most people are inclined to believe that PSBs face problems because of massive government interference in the sanction of loans. As many PSB bankers will readily testify, such interference has come down sharply over the years and it is possible for a bank chairman to stand up to it.
The committee’s answer to the governance problem, creating a BIC headed by a professional banker and with bankers as directors, is infeasible and misguided. The proposal is misguided because it would vest a group of professionals running the BIC with control over the entire set of PSBs. The dangers of such concentration of power are so great as to make one shudder.
The proposal is infeasible because the idea that the government as the principal stakeholder, which is accountable to Parliament, should not exercise any control over the board is unlikely to find political acceptance. Way back in the late 1990s, Vijay Kelkar, who was then finance secretary, had proposed a holding company for public sector undertakings (PSUs). The idea remained stillborn. In the case of banks, which still need government funding and that have an implicit government safety net, it is hard to visualise such a proposal going through.
Problems with the UK Model
In 2008, the UK government set up the UK Financial Investments (UKFI) in order to manage its stakes in British banks which the government had bailed out. The report cites the UKFI as an appropriate model for India. It contends that UKFI “is viewed as a buffer between the banks and politicians, and acts as an informed shareholder”.
Really? The Lex column of Financial Times recently had this to say of the UKFI:
One sort of person will start shouting about how UKFI is an indecent figleaf balanced on the angry tumescence of the state’s control. UKFI never votes its shares contrary to its master’s wishes. Other complainants will fume and spit over how UKFI’s ex-banker management would always approve grotesque bonuses for their mates, if the government did not intervene (14 May 2014).
Consequent to the bailout, the UK government has had its say in the choice of CEOs in banks under its ownership as well as the payment of bonuses. This underlines an important truth that seems to have eluded the Nayak Committee: the government cannot distance itself from control over banks in which it is the majority shareholder.
The report also cites the case of UTI Bank, since changed to Axis Bank. The government transferred its majority stake to a special purpose vehicle and then allowed it to fall below 50%. This has generated enormous returns to the government. UTI was a new bank and hence could do things very differently from an existing PSB. It was a small bank, so the government could risk relaxing its control. These are not things that can be replicated with a whole set of larger banks: the risk to systemic stability is too high.
The report argues that repealing the Bank Nationalisation and other related Acts and bringing PSBs under the Companies Act is preferable because the Companies Act of 2013 has stronger provisions on governance than the existing Acts that cover PSBs. This is a rather specious argument. The Securities Exchange Board of India (SEBI) has strengthened clause 49 of the listing agreement, bringing it in line with the provisions of the Companies Act and making it stronger in some respect. PSBs, being listed entities, are covered by clause 49.
Employee Compensation
The fourth premise is that the PSBs can fare better only if they have the same level field as private banks with respect to employee compensation: This is one of the most-cited arguments for privatisation anywhere in the world. The public sector can never compete with the private sector for talent, hence privatisation is inevitable.
This is not the place to explore the complex issue of pay and performance. It suffices to make a few points. One, in respect of base pay, it is important to compare cost to company (including pension benefits). When one does that, the difference in pay may not appear as glaring as is generally supposed.
Two, in respect of variable pay, there is scope for improvement at PSBs. However, trying to catch up with the private sector is likely to seriously damage the cost structure of PSBs and render them uncompetitive.
Three, in banking, one must always be alive to the link between executive pay and systemic risk. The world’s leading banks showed great performance in the years leading up to 2007 and they could well have claimed that it was because they knew how to reward talent. It turned out that it was precisely the reward system that was a cause of the crisis.
The challenge in the Indian banking system may not be just of raising public sector pay to private sector levels. It may equally be one of reining in runaway compensation at private sector banks. The committee has recommended stringent penalties for private banks that resort to ever-greening of accounts to avoid provisions. Has the committee picked up something that has not filtered into the public domain?
The fifth premise is that the PSBs’ requirements of capital under Basel 3 are so onerous that government will not be able to make the contribution required to maintain majority ownership: The committee arrives at this conclusion on the basis of projections that veer towards the pessimistic. For instance, it uses the return on equity of the last three years when there is every likelihood that the outlook for the coming years will be better.
In the best case scenario, it projects an annual requirement of government funding of about Rs 30,000 crore. Other independent forecasts put the figure at closer to Rs 25,000 crore. This is, of course, a high figure but not one that is beyond the capacity of the government if we assume a gradual return to a high growth path.
That apart, there is no call to lump all PSBs together and propose a one-size-fits-all solution – privatisation – for all of them. It would make more sense to distinguish between the stronger and weaker banks. For some banks in the latter category, we could consider a dilution in government ownership below 50%.
Common Governance Issues
There are a large number of issues of governance that cut across both the public and private sectors in Indian banking. It should be possible to address the problems at most PSBs within the framework of government ownership. There is nothing about government ownership that comes in the way of the board of a public sector company being professionalised and empowered. The committee might have looked at the record of the new prime minister. During Prime Minister Narendra Modi’s tenure as chief minister, Gujarat showed that PSU boards could be professionalised and PSUs turned around smartly.
The committee says that seven key themes, including strategy and risk management, do not get the attention they deserve at PSB boards. The committee is of the view that private banks table more relevant issues than PSBs. It suggests that this could be a factor that private banks’ superior performance (despite the fact that in both categories of bank, less than 6% of issues tabled related to strategy and risk mitigation). This weighty conclusion is based on a perusal of the minutes of just one board meeting at banks in the sample.
The report even has a graph that shows a closer correlation between board issues tabled and returns. One can wager that the committee would have found an even better correlation between the quality of boardrooms and bank performance!
Three Initiatives for Boards
Boards, in general, are ineffective and this has little to do with ownership or the absence of adequate expertise or skills on the board. The way forward is not to predicate improved governance on a change of ownership. If owners, public or private, are not doing what it takes, the regulator must step in. There are three initiatives the regulator might take.
One, lay down stringent fit and proper criteria for membership of bank boards and also a broad profile of the skills or expertise needed. (There is a certain composition the RBI now prescribes but this needs to be updated.)
Two, ensure that board members are selected by diverse stakeholders. The central problem today is the way the boards are constituted. As long as boards are constituted entirely by the promoter or management, boards are fated to remain ineffective. We need genuine diversity in the boardroom with representation for institutional and minority shareholders at the very least.
Three, introduce an objective filter in the selection of board members. The Financial Services Authority (FSA) of the UK interviews candidates for board positions in the financial sector and does not hesitate to reject those found suitable. The time is ripe to consider instituting such a process here.
Central Problem of Management
The central problem at PSBs is not governance by the board. It is one of management. Management is one of the key differentiators between public and private sector banks. The problems are well known and were spelt out by a committee headed by A K Khandewal in 2012.
There is, first, the complete decimation of senior and top management at many PSBs because of the hiring freeze that operated for several years. Second, there is poor succession planning. We have managers hopping from one PSB to another at the executive director and the chairman and managing director levels. Managers occupy these positions without any familiarity with the culture of the bank, and leave just when they have to come to grips with it. This must stop. At the top level, the attempt must be to select from a panel of senior officers groomed for the position over a long period of time.
Third, there is a lack of expertise in areas such as treasury, wealth management and risk management. In these areas, PSBs should have freedom to hire people on contract from the market on terms that may not fit into the public sector framework of compensation. Then, there are the nuts and bolts of human resource development that have got neglected: career planning and job rotation; performance management systems; high-quality training, etc.
The issues of management as well as governance at PSBs can be addressed without being fixated on the notion that the public sector is congenitally incapable of addressing these. What is required is a combination of political will and decisive regulatory intervention.
The Nayak Committee’s proposal to privatise PSBs has little chance of going through. It will be fiercely opposed by bank unions as well as political parties. Repealing the various bank-related acts will be difficult, given that the new National Democratic Alliance government lacks the numbers in the upper house.
Not least, the dangers of handing over the banking system to a clutch of professionals – individuals who are unelected and unaccountable to Parliament – are so great that no government can contemplate such a course with equanimity. It would be unfortunate if, in burying the privatisation proposal, we also end up burying the live issues of governance and management in the banking system.
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