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Insights into Editorial: The govt and RBI face a trilemma regarding PSBs

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Introduction:

Former Reserve Bank of India (RBI) governor Urjit Patel in his new book Overdraft Saving the Indian Saver, talks about a trilemma facing the Indian central bank and the government, when it comes to the public sector banking system in India.

What is the trilemma about?

The sovereign (government) and the regulator (RBI) face a trilemma: It is clear that it is not possible to:

  • Have dominance of government banks (public sector banks) in the banking sector;
  • Retain independent regulation; and
  • Adhere to public debt-gross domestic product (GDP) targets.

The government along with RBI cannot hope to achieve all three points at the same time.

Only two out of the three can be achieved:

  • Predominant public sector and independent regulation by RBI.
  • Predominant public sector and adherence to debt to GDP targets.

Let’s say the government wants the public sector banks (PSBs) to dominate the banking system and at the same time ensure that the public debt doesn’t go up.

What will happen in such a circumstance?

In this scenario, the Reserve Bank will have to compromise on independent regulation.

To dominate the banking system, PSBs will have to increase lending at a fast pace.

This will lead to accumulation of bad loans or loans that haven’t been repaid for 90 days or more.

Given that the recoveries of bad loans are minimal, the government, as the owner, will have to invest more money into the PSBs to keep them going.

If the government puts more money into the PSBs, its expenditure will go up. It will have to borrow more money and the public debt to GDP ratio will substantially rise.

How can public debt to GDP ratio be saved from rising?

The central bank will have to dilute some regulations to help the PSBs in not recognizing bad loans.

In such a case, the government need not invest in the PSBs immediately. PSBs will have a greater market share and the public debt to GDP ratio will not rise right away. However, the central bank will have to dilute banking regulations.

What is the issue with RBI diluting norms?

When RBI dilutes regulations, banks end up kicking the bad loans can down the road.

This postponement leads to a bigger problem, which hits the banks, not immediately, but a few years later.

This is precisely how PSBs accumulated peak bad loans of ₹8.96 trillion, as of March 2018.

The government then has to recapitalize the banks in the years to come. In the process, it pushes the public debt to GDP ratio up. This is one situation that the government has been trying hard to avoid.

Arguments for reducing government dominance on Public Sector Banks (PSBs):

The basic argument that has been making has its roots in the discourse on banking reform and reducing dominant state ownership and control over the banks.

There is an assumption that state-owned banks have a sovereign guarantee and, therefore, safe from the depositors’ perspective. But sovereign ownership also creates a sense of performance complacence.

The punishment by the stock market for non-performance is blunt but it does not ostensibly harm the dominant shareholder.

It is the minority shareholder who suffers at the first instance and then (if the insulation of the sovereign is removed) the saver.

However, if there is a large overlap between savers and tax payers then they are paying the price for saving themselves at one end even as the cost of finance for the economy does not go down.

The cost of non-performing assets and administrative overheads ultimately has to be recovered from the profits — a reason that indicates that interest rate cuts do not get transmitted.

Conclusion: Eventual way out for RBI and government:

The decline in the share of government banks in the banking sector should not be resisted.

Current trends broadly suggest that the banking sector is increasingly privatized, by stealth, much like the telecom sector.

In the last decade, the share of PSBs in overall lending has dropped sharply from 75.1% to 57.5% at present.

As PSBs keep losing share, they will cause fewer headaches for the government and the central bank in the decades to come.

While India does face this trilemma as proposed by the former governor, unchecked privatization may not be the solution.

A balanced approach is needed where the resolution process of financial failure of private banks needs to be evolved. These norms must address how to secure depositor interests.