OPINION | Bank mergers may be a prelude to government’s partial exit from ownership

# Overall bank credit grew at a CAGR of 12% while PSU banks grew at only 8%.

# Though their gross NPAs nosedived steeply by 16%, this was more on the back of write offs than recoveries and PSU banks were making losses from 2017 until 2020.

# Their combined assets at Rs 1.95 trillion now form about 55% of the banking sector but the creation of world class banks seems far away.

Even if we accept the rationale, the timing is intriguing especially only five years into the earlier amalgamation and which was yet to demonstrate any clear benefits.

Will IMF-World Bank assessment catalyse mergers? 

The publication of the Financial Sector Assessment report 2024 (FSA) by the IMF-World bank combine recently perhaps was an inspiration, as it makes some pointed suggestions in this regard. While positive about the resilience and diversity of the Indian financial system, it highlights a few disconcerting features- one, the role of the State although diminishing and, two, the increasing role of non-banking actors.

The FSA report says banks are now resilient and even the 2016 banking sector distress was due to defaults by power and infrastructure companies and not related to macro financial conditions. This may be true since the power sector was beset with known problems-regulatory, coal, the health of distribution companies to name a few, while roads were saddled with PPP issues, regulatory delays and tariff issues.

But the larger point is that the PSU banks perhaps were forced into infrastructure due to the absence of specialised term lending institutions such as the IDBI and ICICI and the Government’s push for infrastructure. Even sans macroeconomic issues, banks were clearly ill suited for the job, given their asset-liability profiles and the lack of project appraisal skills.

Risks of infrastructure lending have not really been taken of banks’ books

The report believes that the problem of funding infrastructure has not gone away but has only shifted from banks to NBFCs. This is a concern because the increasing exposure of large state-owned infrastructure financing companies could spill over to banks, on whom NBFCs are still dependent. But lacking many of the regulatory guardrails that banks had, NBFCs are more vulnerable. The WB-IMF’s concerns are genuine but the solutions may not necessarily lie in tightening regulations for NBFCs.

Growing footprint of NBFCs

In fact, the refrain of the report seems more about NBFCs than banks, because in the seven years since the last report, non-banks have come to finance almost half the credit to the private sector. The worry was that that NBFCs were on shakier grounds and macro scenario solvency tests masked critical vulnerabilities from concentration risks to power sector. The fact that NBFCs’ liquid assets were only a little over 5% of total assets, gave rise to fears that the next systemic liquidity event could arise from NBFCs.

A point that the report perhaps misses is that this was not a case of NBFCs rushing in where banks feared to tread, because these state-owned NBFCs had existed a long time before they became RBI regulated NBFCs and had been set up specifically to finance infrastructure projects.

IMF-World Bank feel State investment doesn’t provide bang for the buck

The other important feature of the report is about the role of the State. It has specific prescriptions in this regard relating to capital, priority sector lending, regulations and even the IBC code. It wants the State to redefine its role, reduce its footprint to increase efficiency and mobilise private capital. It says the Government had spent 1.1% of 2023 GDP (US$38.8 billion) to recapitalize 21 PSBs from FY18 to FY21, but got little in return.

Calling for partial government exit from bank ownership

A far-reaching recommendation is on the privatisation of select PSBs and insurance companies by increasing private ownership and removing the 20% foreign investment cap. It also wants the exemptions for state-owned NBFCs from some of the prudential standards to go.  These are all known problems but then our financial system architecture is a legacy issue.

Low income and low savings necessitate a large role for the State but also limits the potential for taxation, which means large borrowings to fund the State. Large debt requires a large base of subscribers, a role which banks have been playing but at the cost of pre-empting long-term savings in favour of the Government, leaving little scope for debt or bond markets.

Raghuram Rajan called it a grand bargain where in return for capital, low cost funds and safety, banks would subscribe to government securities, lend to priority sectors and open branches.

The rationale for more mergers at this stage is not very convincing but perhaps the government is now beginning to see some of the limitations of the model. With likely increased demands for capital that could arise post the new Basel ECL (expected credit loss) regime, the low returns on equity and the impact on private savings, the urge to merge may well be the first of the steps to exit the system, though that could take a long time.

(SA Raghu is a columnist who writes on economics, banking and finance.)

Views are personal, and do not represent the stand of this publication.