There is an obvious irony of the recent developments in the banking system in India and the United States. Stimulated by a lack of financial inclusion, the public banking movement in the United States, a stronghold of free markets, is steadily gaining momentum. By comparison, India, a prime example of state interference and government-owned banking domination, seems to be rapidly warming the concept of bank privatisation. There is no new discussion on the advantages and costs of public versus private banks. Government involvement in the banking sector helps the way of overcoming market failures in the early stages of economic development.
Convinced by evidence that government ownership in the banking sector contributes to lower levels of financial development and growth, waves of privatisation in the banking sector swept through emerging markets in the 1990s. Consensus policymakers saw the privatisation of banks as an effective way of achieving economic and financial growth. Indeed, cross-country evidence shows that bank privatisation has increased both, bank performance and profitability—specifically, rising solvency and liquidity while reducing distressed or non-performing assets. Therefore, India is a little late to the game.
Public sector banks (PSBs) dominate Indian banking, holding more than 60 per cent of banking assets. The ratio of private credit to GDP, a primary indicator of credit flow, is 50 per cent, much lower than international benchmarks—in the US, it is 190 per cent, in the UK, it is 130 per cent, in China, it is 150 per cent, and in South Korea, it is 150 per cent. The standard of credit is also troublesome. India’s gross NPA ratio was 8.2% in March 2020, with marked disparities between PSBs (10.3%) and private banks (5.5 per cent). The end result is much lower profitability of PSB relative to private banks. Clearly, the argument for privatisation derives from these reasons.
Public banking can also help with efficient government transactions and financial inclusion through universal audit accounts. According to pre-pandemic statistics from the Federal Deposit Insurance Corporation (FDIC), 5.4% of households in the United States are unbanked. India is no stranger to the need for digital financial inclusion. Jana DhanYojna (PMJDY) is a flagship scheme designed to address slippages in the delivery of transfer payments to ultimate beneficiaries. The programme is conducted predominantly by government-owned banks.
The stellar performance of Indian PSBs in implementing the PMJDY while missing a mark on creating high-quality credit highlights, the crucial gap between the asset and the bank’s liability side. Banks have two basic functions: payments and deposit-taking on the liability side and the production of credit on the asset side. The payment services feature, a hallmark of financial inclusion, is similar to a utility business—banks should uniformly offer this service, a public benefit, at a low cost. On the other hand, the lending side is all about the optimum distribution of capital by better performance assessment and tracking of borrowers.
Private Banks are more likely to have the right combination of incentives and experience to do so. It does not come as a surprise that PSBs in India are best suited to providing public good functions, whereas private banks seem to be better suited to credit allocations. The best combination of public and private banking systems comes down to what you need from your banking system and the specific friction your economy faces.
