PSB privatisation: Beware the ‘foreign hand’

The paper ‘Indian Banks: A Time to Reform?’ by Raghuram Rajan and Viral Acharya outlines a three-part process towards privatisation of public sector banks (PSBs). First, move to state-linked banks where government stakes are brought down below 50 per cent, re-privatisation by “bringing in private investors who have both financial expertise as well as technological expertise”, and subsequent further dilution of ownership by capital expansion. This change in ownership, along with other reforms, according to the authors, will result in rapid credit growth without the “boom-and-bust cycle view of credit”, in the country. Really?

Even as I make the case for continued majority ownership by the state in PSBs, I agree with the commentary often heard that these banks are in need of efficiency-enhancing operational changes and should be permitted to function without interference. Of course, the issue of NPAs (non-performing assets)in PSBs should be addressed sensibly through legal and other measures. But in trying to fix these problems, we should not so alter the structure of ownership where the entire sector of banking gets away from the nation. This is what has been proposed, without actually spelling it out.

Ownership of private banks

Let’s look at the ownership of the top four private banks — HDFC, ICICI, Axis and Kotak. As can be seen from the Table, the largest chunk of ownership is with foreign shareholders in all these banks. In the case of HDFC Bank, if we consider that its promoter HDFC Ltd is 70 per cent owned by foreign institutions, nearly 64 per cent of the bank is effectively owned by foreign shareholders.

What this has resulted in is rich valuation for these banks in the stock market. The current limit of foreign ownership in private banks is 74 per cent. There is a proposal to raise this to 100 per cent which is pending with the government.

When Rajan and Acharya suggest privatisation of PSBs, this is what they are proposing: the steady takeover of Indian banking by foreign shareholders. Does this mean more capital is flowing for lending and, therefore, leading to credit growth? The answer is No. A small amount comes into the banks as equity, but the bulk of it is flowing into the stock market to enrich valuations.

To be clear, there is nothing wrong if this is the intent. But to suggest that privatisation will result in increased credit flow to the economy is stretching the point. Credit flow is a function of risk taking by banks, and as the following example in Mexico shows, this does not happen under foreign ownership.

Mexico: A case study

Mexico, a nation with a population of around 95 million in the mid-1990s, went through a financial crisis in 1994-95. What happened thereafter to the banking industry offers a relevant natural experiment with major lessons for India.

The mid-1990s financial crisis in Mexico resulted in a huge banking crisis, which was resolved by a series of government-financed restructuring and capital infusion.

In 1997, Mexico’s banking laws were amended to privatise large banks, and allowing foreign firms, for the first time since the 1880s, to own banks without restriction goal of this legislation was to lower the cost of recapitalising the country’s banks, and to encourage rapid credit growth. This is precisely what Rajan and Acharya have recommended in their recent paper.

What happened thereafter is captured in Working Paper No 228 put out by the Stanford Center for International Development. Titled ‘Foreign Banks and the Mexican Economy, 1997-2004’ and written by Stephen Haber and Aldo Musacchio, the paper sheds light on the outcomes. The relevant results for our discussion are captured in the Graphs 1, 2 and 3. The results of the so-called reforms in Mexican banking were stunning. Mexico lost most of its banking to foreign ownership, a situation that has been irreversible till now.

Graph 1 shows that in a short period of eight years, from 1997 to 2004, foreign ownership of Mexican “banking assets” moved from 15 per cent to 82 per cent. The expression “banking assets” refers to the money of the Mexican people now under the control of foreign shareholders. This happened due to a wave of mergers and acquisitions that put all of Mexico’s large commercial banks in the hands of Spanish, Canadian, British, and American firms.

Graph 2 shows that the goal of rapid credit growth never took place. Housing, commercial and consumer loans which were 47 per cent of total bank assets in 1998 declined to 29 per cent by 2004.

Graph 3 highlights that as privatisation and foreign ownership increased exponentially in Mexico, the percentage of bank assets allocated to housing, commercial and consumer loans declined significantly. According to the authors of the Stanford Working Paper, “It is widely agreed that, since 1997, Mexico’s banks have reduced the amount of credit they provide to households and business enterprises in both absolute and relative terms.” Where do these banks deploy their funds? The authors observe that “they tend to invest in direct loans to government entities and to holding government and corporate securities.” In other words, they followed the practice of minimal risk and maximum returns to keep the shareholders happy.

The conclusions are not surprising. Foreign banks will always operate in the interests of their shareholders and not for the benefit of the country they are operating in. Rajan’s and Acharya’s belief that privatisation (resulting in foreign ownership) will lead to rapid credit growth for the country’s benefit is certainly belied in the Mexican experience.

The writer is Group CEO, RK SWAMY HANSA. Views are personal