Privatising PSBs isn't easy

If a week is a long time in politics, a month or two can be a long time in economic policy. Two months ago, following the Punjab National Bank (PNB) fraud, an enormous clamour had erupted in favour of privatisation of public sector banks (PSBs). With ICICI Bank and Axis Bank in the news for the wrong reasons in recent weeks, the clamour has died down quite a bit. 

Conspiracy theorists say that was the whole point about turning the spotlight on two large private banks — to deflect attention from the problems at PSBs. Conspiracy or no, the issues of governance that have arisen at the two private banks do have implications for privatisation of PSBs. 

Privatisation is all about ensuring greater management accountability for performance. This is ensured by boards of directors that focus resolutely on shareholder value. At PSBs, the argument goes, boards are nowhere as effective as politicians and bureaucrats influence decisions from behind the scenes.

Well, that’s the theory. The problems at two large private banks have reinforced doubts about how well boards in private companies perform in practice. At ICICI Bank, the board failed to respond adequately to charges of conflict of interest. At Axis Bank, the board offered a fourth term to the chief executive officer (CEO) in the face of what analysts viewed as indifferent performance and then chose to backtrack when questioned by the Reserve Bank of India (RBI). Neither board is a great advertisement for board effectiveness. 

You could argue that even if boards are not effective enough, incentives at private banks will still produce superior outcomes. Managers at private banks will deliver performance because they stand to be richly rewarded through bonuses and stock options. ICICI Bank and Axis Bank may have faltered in recent years but they have still fared better than most PSBs. 

Alas, getting the incentives right is also a function of the board. Weak boards that are in thrall to CEOs will hand out rewards unrelated to performance. This is bound to tell on long-term performance.  

The implication should be obvious enough. We can’t privatise PSBs in the hope that this will automatically lead to superior outcomes. We need to understand the conditions under which privatisation will produce results in our context. To begin with, it’s useful to grasp a couple of facts about private banks in India. 

First, ICICI Bank and Axis Bank are both of government parentage. The early success of these banks owed to the trust and controls that are associated with government banks. It is only over time that they came to shed their public sector character and became increasingly board-driven. The experience with these two banks suggests that, in India, the board-driven model may produce results initially but could run into serious problems over time. 

Secondly, the banks that have been completely private sector in character from the word go and are faring well today — Kotak Mahindra Bank, YES Bank, IndusInd Bank — all have a dominant investor. So does HDFC Bank, although it, too, is of semi-government parentage. 

A fair inference is that India has a long way to go before it develops a culture of professional boards accountable to institutional investors. The model that is working better today in private banks is one where a dominant investor calls the shots. 

It won’t do, therefore, for the government to drop its equity stake below 50 per cent and hand over matters to professional boards, as the P J Nayak Committee on bank governance had recommended in 2014. The Nayak Committee saw Axis Bank as the role model for other PSBs to follow. One is not sure that the Nayak committee would think so today. 

At any rate, analysts and investors are unlikely to relish the prospect. The model that will enthuse them is one with a dominant private investor, somebody with “skin in the game”. Since regulations do not allow foreign ownership to exceed five per cent in general, the dominant investor would have to be an Indian industrial house or one of the private banks with a dominant investor. 

Giving a bank licence to an industrial house poses serious systemic risks: The RBI did not give a bank licence to any industrial house in the last round. As for private banks taking over PSBs, it’s not clear they would be keen to do so. The better ones are doing well enough through organic growth. They are likely to find the human resource issues entailed by the acquisition of a PSB daunting.

It’s hard to resist the conclusion that the conditions for privatising PSBs are not in place today. Simply letting go of government control and leaving matters to boards risks creating a dangerous governance vacuum at PSBs. There is, therefore, no realistic alternative to reforming and strengthening PSBs under government ownership. It is ironical that the political class seems to have grasped this reality while those mocking it for not embracing “big bang” reform haven’t.

The writer is a professor at IIM Ahmedabad 

ttr@iima.ac.in

Disclosure: The writer is on the board of IndusInd Bank. Views are the author’s alone