Infrastructure

Public or private? The future of banking in India and US

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One cannot but be struck by the apparent irony in recent banking system trends in India and the United States. Spurred by a lack of financial inclusion, a public banking movement is rapidly gaining traction in the United States, a bastion of free markets. In contrast, India, a prime example of state intervention and government-owned-bank dominance, seems to be quickly warming to the idea of bank privatisation.

The debate on the benefits and costs of public versus private banks is not new. Dating back to Alexander Gerschenkron in 1962, the development view sees government presence in the banking sector as a means to overcome market failures in the early stages of economic development. The core idea is that government-owned banks can improve welfare by allocating scarce capital to socially productive uses. By contrast, the political view argues that vested interests can commandeer the lending apparatus to achieve political goals. Political or special interest capture can distort credit allocation and reduce allocative efficiency in government-owned banking systems.

Persuaded by the evidence that government ownership in the banking sector leads to lower levels of financial development and growth, waves of banking sector privatisations swept across emerging markets in the 1990s. The policymaker consensus saw bank privatisation as an efficient means to achieve economic and financial development. Indeed, cross-country evidence suggests that bank privatisations improved both bank efficiency and profitability — specifically, increasing solvency and liquidity whilst reducing troubled or non-performing assets. India is, therefore, somewhat late to the game.

Public sector Banks (PSBs) dominate Indian banking, controlling over 60 per cent of banking assets. The private-credit to GDP ratio, a key measure of credit flow, stands at 50 per cent, much lower than international benchmarks — in the US it is 190 per cent, in the UK 130 per cent, in China 150 and in South Korea it is 150 per cent. The quality of credit is problematic as well. India’s Gross NPA ratio was 8.2 per cent in March 2020, with striking differences across PSBs (10.3 per cent) and private banks (5.5 per cent). The end result is much lower PSB profitability compared to private banks. Clearly, the rationale for privatisation stems from these considerations.

While the United States epitomises the private banking model, a nationwide public banking movement is coming into vogue —this includes recently introduced state bills from California to New York. If modelled along the lines of the Bank of North Dakota, America’s only public bank, reports suggest that public banks can contribute to state revenues, support community banks, fund public infrastructure projects, and help small businesses grow by offering lower interest rates and lower fees.

The public banking movement can also help with efficient government transfers and financial inclusion via universal checking accounts. According to pre-pandemic data from the Federal Deposit Insurance Corporation (FDIC), 5.4 per cent of the households in the United States are unbanked. India is no stranger to the imperative for digital financial inclusion. The Jana Dhan Yojna (PMJDY) is a flagship scheme designed to overcome slippages in delivering transfer payments to ultimate beneficiaries. The programme is administered primarily through government-owned banks.

The stellar success of Indian PSBs in implementing the PMJDY while missing the mark on creating high-quality credit highlights a critical divide between the asset and the liability side of a bank. Banks provide two functions at a fundamental level: Payments and deposit-taking on the liability side and credit creation on the asset side. The payment services function, a hallmark of financial inclusion, is similar to a utility business — banks can provide this service, a public good, at a low cost universally. The lending side, in contrast, is all about the optimal allocation of resources through better credit evaluation and monitoring of borrowers. Private banks are more likely to have the right set of incentives and expertise in doing so. It comes as no surprise that the PSBs in India are better at providing the public good functions, whereas private banks seem better suited for credit allocation.

The optimal mix of the banking system across public and private boils down to what you need out of your banking system and the particular friction your economy faces. When the wedge between social and private benefits is large, as with financial inclusion, there is a strong case for public banks. At this stage, inefficiency in capital allocation seems to be a bigger issue for the Indian banking sector, whereas, in the US, the debate is centred around the public goods aspects of banking. Therefore, it may make sense for the US to think hard about public banks that can be used for financial inclusion in line with the success of PMJDY in India. On the other hand, selective privatisation of inefficient PSBs is a welcome move for India’s banking sector.

Chari is Professor of economics and finance and director of Modern Indian Studies Initiative, University of North Carolina at Chapel Hill and Purnanandam is Michael Stark Professor of Finance at Ross School of Business, University of Michigan

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