Public sector banks can get a big leap forward

A Bank Investment Company to act as a holding company for state-owned banks would go a long way in minimising government interference and improving governance, says Pratip Kar.

A definitive characteristic of the report of the P J Nayak Committee to review governance of bank boards in India is that it is entirely data-driven and analytical. This makes the findings of the report incontrovertible, discomforting though these may be to many advocates of status quo.

The report covers governance of banks in the public and private sectors, but this article focuses on the public sector banks (PSBs) since they play a significant role in the Indian economy.

When the report states at the very beginning that "the financial position of public sector banks is fragile", it is merely drawing attention to a grim reality. Researching the performance of these banks over long periods is certainly of great academic value, but the findings would not alter the sternness of the current day reality for the PSBs - a reality that the government and the Reserve Bank of India (RBI) can little afford to ignore.

Indeed, the very appointment of a committee to examine the governance of bank boards, by RBI Governor Raghuram Rajan, within a few months of his assuming office, presumably reflects his deep concern in this area.

The diagnostic and discussions in the report show that the current profitability and productivity ratios of PSBs are weaker than their private sector competitors and they are gradually losing market share to the latter.

Their stressed assets are accelerating, and the growing need for recapitalisation is daunting. For example, the committee has estimated that even "in an extremely prudent scenario the PSBs would need Rs 5.87 lakh crores of tier-I capital during the period January 2014-March 2018". The report observes that recapitalisation at such a level is bound to "impede fiscal consolidation, affect fiscal stability and eventually impinge on the government's solvency". 

But what has brought PSBs to this precipice? Largely, governance deficit in these banks. The report suggests that the government has two rational choices - either to privatise PSBs or if the government wants these banks "to continue to play a pivotal public sector banking system", which one assumes it would, then it needs to "design a radically new governance structure" to "manage these banks efficiently". 

Corporate governance of PSBs suffers from the same ills as public sector enterprises commonly do in different degrees in different countries. For example, there are conflicting objectives inherent in the state's role as a shareholder, owner and an enterprise manager who is required to run the business profitably and also equitably provide universal services to all its citizens even at a low cost, if it serves the interest of its citizens, to extend the service into unprofitable areas, to ensure employment, to develop infrastructure in economic backward areas and so on.

In pursuit of these objectives, the state also has a responsibility for "actively exercising its ownership functions, such as nomination and election of the Board, while at the same time refraining from imposing undue political influence in the management of the company"(1). The above philosophy underpins the manner in which PSBs have been controlled and administered in India since bank nationalisation. But in the face of the grim reality that PSBs face now, it is time to think and do things differently. 

The boards are central to the governance of any enterprise. The genesis of board dysfunctionality can be varied, but a weakly constituted board by definition inheres in dysfunctionality. The way the constitution of the bank boards has been iron caged by the Bank Nationalisation Acts of 1970 and 1980, and the extent of government and RBI control, these banks have been subjected to, in contrast to the private sector banks, significant curtailment of their operational freedom.

It is ironic that the government should be discriminating against the very banks it owns, by limiting their freedom to operate, and itself suffering low or often negative returns in the process.

How could PSBs have greater breathing space, operational independence and empowerment, without the government relinquishing ownership? The report suggests that the way to this is to set up a bank investment company (BIC) as a holding company for PSBs. The BIC will help distance the government from the boards and managements of PSBs, without any loss in its ownership of the banks.

The BIC would "hold equity stakes in banks which are presently held by the government" and be constituted as a core investment company under RBI registration and regulation. A shareholder agreement between the government and BIC would assure the latter of its autonomy, and set its objective in terms of financial returns from the banks it controls.

The board of the BIC would be professionally constituted with a professional CEO, a non-executive chairman nominated by the government and independent directors with adequate skills and expertise. The report recommends a gradual three-phase implementation for the transfer of the government holding in banks to the BIC - repeal of the bank nationalisation Acts, the transfer of the existing ownership functions from the government to BIC and to the fully empowered bank boards in the final phase.

This transitioning of powers from the government to BIC would also mean the government moving from its role as a sovereign and owner, to an investor who is concerned with maximising shareholders' wealth (i.e. taxpayers' wealth). In step with the phased changes, the dual regulatory structure of RBI and the government should end.

The government should cease to issue any regulatory instructions only to PSBs. The RBI, as the sole regulator for banks, should apply the regulations uniformly to all commercial banks. The government will be able to pursue any developmental objectives in consultation with RBI, provided the instructions are issued only by RBI, and more importantly, be applicable to all banks.

The holding company concept has been successfully implemented elsewhere in the world. One good example described in the report is the UK Financial Investments, which was set up in November 2008 after the financial crisis, exclusively to manage HM Treasury's shareholdings in stressed banks that subscribed to its recapitalisation fund. It has HM Treasury as its sole shareholder.

It is managed by its professional board and is accountable to the Chancellor of the Exchequer and - through the Chancellor - to Parliament. Any argument to reject this concept on the ground "not invented here" would be somewhat childish.

But the above changes hinge on the repeal of the two bank nationalisation acts. These statutes may have served their useful purpose at the time of bank nationalisation, but have now become anachronistic. But the repeal of these acts will hurt the embedded pockets of dominant logic and deeply entrenched vested interests that have been reaping the benefits under these Acts.

These will strongly resist and thwart any change to the status quo. Resoluteness of the government and a strong political will be needed to overcome these. Hopefully, the current government with its emphasis on good governance should be able to make these changes happen.

The writer was a member of the P J Nayak Committee and a former executive director of Sebi. These views are personal.

(1) - OECD Guidelines on Corporate Governance of State-Owned Enterprises)