Tomorrow's banks, today's challenge

Public sector banks (PSBs) and the development financial institutions (DFIs) played a stellar role in the development of the nation with high social content and commitment.

It is a different matter that these obligations were discharged in the interest of the nation and not always necessarily on pure commercial terms.

It must also be recognised that these institutions, being owned by the government, had to follow policies in the 1970s and 1980s that were meant to reduce inequities and regional imbalances in the system and, therefore, a certain degree of credit dispensation "on behest" was inescapable.

While this is understandable up to a point, these institutions went on to function as surrogate entrepreneurs and, in the process, changed beyond recognition the structure of corporate governance and inter se relationships between the different stake holders.

The political executive and bureaucracy step far beyond what is required for compliance with parliamentary accountability. They have recklessly distributed their patronage in the selection of people for the boards and the management.

Often political convenience has taken precedence over merit and competence. It has since been proposed that the government will reduce its holding to one-third of the share capital and ask PSBs to raise additional capital from the market.

At the same time it is declared that PSBs will preserve their public sector character. Is it to be presumed that the state is committed to the continuation of surrogate management?

This would be tantamount to a paradox in policy intent. To allay such unintended misgivings, it is necessary that in institutions, particularly financial, where the state is the owner, it has to distance from the role it is accustomed to (controlling the institution by fiat) and move deliberately and effectively to redefine its role as a facilitator of institutional changes.

To embark on a policy regime that seems to legitimise the persistence of entrenched groups, creating in the process a paradoxical situation, would be to sow the seeds of disaster all over again.

What happened in the Unit Trust of India (UTI) was not a random spasm. Meddling in a trap set by different interest groups, many PSBs and a few financial institutions see their own reflection in the UTI mirror.

This is the first and foremost issue that a national debate should address "" the role of the state in the financial sector where ownership, whether in part or full, rests with the state.

As long as the overriding mantra for banks is capital adequacy and capital adequacy alone "" not just at any point of time, but on an ongoing basis "" it is difficult to visualise that banks that exist as of now will all continue to do so in the next five years or so. A few will; most won't.

Recapitalising weak banks is no longer possible. On the other hand, prudential norms will only get tighter. Therefore, how should the banks prepare themselves either to continue or to exit?

Apart from the State Bank of India (SBI), there are just about four or five other large PSBs that can be expected to hold on their own in the years ahead.

They need to get their act together on two fronts, take their level of provisions for bad debts to 70 per cent, from their current levels of 40 to 60 per cent; and put in place appropriate technology of world-class standards that will make them be seen more as virtual banks rather than brick and mortar.

This will lead to consolidation of their respective network, which may stand reduced to 40 or 50 per cent. They must be given autonomy "" operational and administrative "" and be completely board driven, including in the selection of the chief executive officer.

Finally, they must be taken out of the purview of the Central Vigilance Commission, even if it entails bringing them under the Companies Act.

There are two or three PSBs that are sound in financials but not big enough to carry the day on their own. In fact, they are targets for takeover even now, with potential suitors prowling around. Who should decide their future: the state or the market?

There is the third rung of PSBs, where the problem is a lot more serious to handle. There will be political compulsions to keep them going but the markets may not allow for that beyond a point.

It is best that they tidy themselves up in the time they have at their disposal: raise their provisioning for bad debt up to, say, 50 per cent of their loan losses; reduce their network considerably; and shred unproductive business practices of the past.

In fact, for the vulnerable category of banks, it might make sense to segregate the assets and liabilities of different business segments and re-integrate them in a manner that will appeal to different players in the market "" other Indian banks, financial institutions and foreign banks.

The problems specific to each PSB have to be left to be tackled by a board specifically selected and manned by people who can combine professionalism with a flair for democratic accountability, with operational freedom and flexibility insulated from interference from bureaucratic and political establishments.

The DFIs flourished under a protected regime and freedom from regulatory authorities, extending term loans and project finance from a subsidised source of funds.

In retrospect, it would now seem that it was these two so-called blessings that worked against them. Loans "on behest" carried on with gay abandon, which submission to some sort of regulatory control and observance of prudential norms could have stemmed to a certain degree.

With the rules of the game changed, they have to compete with commercial banks (who also undertake project financing) on even terms to raise resources cheaply "" something they cannot do without retail outlets.

Their obsession to convert to universal banking, though logical, is impractical, unless they merge with commercial banks large enough to sustain them in the long run.

Even the second-largest bank, recently created via a reverse merger of the off-spring with its parent organisation, will not be able to sustain beyond the near future, unless it looks outwards for external sources of finance that will be viable in the long run.

There are two types of private sector banks, the old and the new. As far as the old (mostly regional banks) are concerned, inadequacy of capital will lead to their mergers sooner rather than later.

As for the new banks, it is true that they started on a clean slate, became technology-savvy and offered attractive products and services, but it is still too early to assert that their corporate governance and risk management are far superior to that of the PSBs.

Already, their shakeout is imminent as evidenced by a couple of mergers. The rest will share the same fate. The exception is HDFC Bank "" which can be called a classic role model for private sector banking "" whose future looks promising. But even HFDC Bank will be compelled to shift from organic growth to acquisitions to reach a critical mass to stand alone.

There have been quite a few foreign banks operating in India, and there are at least five that have completed 100 years of operation each. For the most part, they all had to be satisfied with muted growth over the years given policy constraints.

However, with the opening up of the economy, their prospects for growth and expansion brightened. This is not to mean that all of them will do so.

In fact, in the recent past, at least three banks have taken the exit route. As of now, there is evidence to suggest that at least three major international banks will get aggressive on the Indian banking scene "" Citibank, ABN-Amro and HSBC. But in the foreseeable future, one can expect three or four banks from the US, two from Europe and two from east Asia, to make their presence felt in India.

In any banking system, no bank "" public or private "" can survive unless it continuously strives to transform its organisation into a self-governing, self-correcting and self-adjusting entity.

For banks to grapple with these problems and manage the future, structural and institutional rigidities need to be eased in two critical areas: comprehensive legal support for recovery of bad debts and a fundamental change in the pattern of governance for the PSBs.

While the recent ordinance for recovery of bad debts and securitisation of assets is a godsend, it remains to be seen whether dilutions to it take place when the bill is finally passed.

Finally, throughout the history of nations, mankind had one master to serve: the owner, first as a slave, and once the loyalty test was won, as a servant "" a universal truth for the past two millennia.

In this millennium, however, mankind is destined to serve not one but two masters: the first is no longer the owner, but the customer, who is king regardless of whether he is rich or poor, young or old, domestic or foreign.

The second is profits. There is no third. Just as "income recognition" and "capital adequacy" are two sides of the same coin, this is also the case with "customer satisfaction" and "profits".

(The author is former chairman of Indian Banks' Association and chairman and managing director of Union Bank)