India: Do We Need To Privatise Our Banking Sector?

By S. S. Sagar Priyatham & K. Prathima

Privatization is transfer of ownership or control over assets or activities from the public to the private sector. In broad terms, privatization involves greater market force, ensures higher competition, reduces the role of the state in the economic sphere and thus brings in greater private involvement into government activities. It liberalizes different regulations to unleash forces of competition and to induce market forces into the economy. It is also referred to as structural adjustment programmes for the economy as a whole and as an element of broader economic policy. However, in its strict sense, privatization refers to divestiture to private entity¹. Privatization, one of the policy reforms, is meant to improve the efficiency of state owned enterprises².

The Committee on the Reforms of the Financial System (1991), under the chairmanship of Mr. M. Narasimham had recommended for reforms in the financial sector. Banking and insurance are the two key factors of the financial sector³. The Government has welcomed the establishment of private banks and is encouraging privatization of public sector banks and extension of private banks.

Banking Industry in India has always revolved around the traditional function of deposits and credit. Their role has been defined to assist the overall economic growth with majority of shares being controlled by the Government of India in most of the banks. But with the process of Liberalization, the banking industry has also undergone tremendous change in the last 5 years. The rules of the game have been changing with RBI introducing new norms to make banks more accountable and to adopt the practices followed worldwide.

This article considers arguments on either sides of the coin, i.e., should Constitutional obligation be our fundamental priority or should Privatization policy be the primary concern to our Indian economy? It tries to analyze which situation our economy would be more benefiting or in other words, situation that can put Rawl’s ‘Distributive Theory’ and Bentham’s "Theory of Utilitarianism" in a realistic way in India.

As part of reforms process in the financial services sector, the R.B.I. issued in January 1993 guidelines for licensing of new banks in the private sector. After 8 years it has revised its guidelines in January 2001.

Some of the important conditions of revised guidance issued by the RBI for the entry of new banks in the private sector are as follows:

The initial minimum paid up capital for a new bank would be Rs.100 crores. The initial capital should be raised to Rs.300 crores within 3 years of commencement of business. The overall capital structure of the proposed bank would have to be approved by the RBI.

The promoters’ contribution will be a maximum of 40% of paid up capital of the bank at any point of time. The initial capital, other than the promoters’ contribution can be raised through public issue (or) private placement. The Promoters contribution of 40% will be locked in for 5 years from the date of licensing of the bank. Similar conditions would apply within 3 years of commencement of business.

Non-resident Indian participation in the primary equity of a new bank will be to a maximum extent of 40%. In case of foreign banking (or) finance acting as a technical collaborator (or) Co-promoter, equity participation will be restricted to 20% within the above ceiling of 40%. In case of shortfall of foreign equity contribution of NRI’s then multilateral institutions would be allowed to contribute foreign equity to the extent of shortfall in NRI contribution of the equity. The necessary approval of FIPB should also be obtained.

A large industrial house will not be allowed to promote new banks. However individual companies, directly (or) in directly connected with new banks can be permitted to participate in the equity of bank up to 10% limit and this is applied to all interconnected companies of large business house.

The bank will be required to maintain a minimum capital adequacy ratio of 10% on a continuous basis from the commencement of its operation.

The constitutional method in India facilitates eradication of social inequalities and exploitation. The framers of Indian Constitution in its Preamble declared that the citizens should be secured.⁴

Supreme Court in Chandra Bhavan Boarding v. The State of Mysore⁵ declared the constitutional philosophy in the following words:

"The mandate of the Constitution is to build a welfare society in which justice, Social, economic and political, shall confirm all institutions of national life. The hopes and aspirations aroused by the Constitution will be belied if the minimum needs of the lowest of our citizens are not met". A reading of Article 38 and Article 39 of the Constitution of India gives the idea that for greater equality among people, all monopolizing tendencies should be discouraged⁶.

Supreme Court in Tara Chand Vyas v. Chairman & disciplinary Authority⁷ held that distribution of material resources as laid down in Art. 39 (b) of the Indian Constitution is the means for the development of the weaker sections.

Petitioner in this case was a branch manager in a Gramin Bank. The charges against him were that he made dereliction in his duty in making payment of loans without ensuring supply of implements to borrowers and deposit of adequate security from dealers.

While observing that, the employees and offices working in banks were not merely trustees of the society, Court held that banking business and services were nationalized to achieve the objects of socio-economic development of weaker sections of society. Court in this case affirmed its stand taken in Dalmia Cement (Bharat) Ltd. and another v. Union of India and others⁸. In that case court held that the right to socio-economic justice in the trinity, the preamble, fundamental rights and directives is to make the quality of life of the disadvantaged people meaningful.

Now-a-days emphasis is being shifted from social justice towards economic development.⁹ The IMF’s economic surgery under the 1991 New Economic Policy required the Indian government to cut spending in social programmes and sell off the more profitable public enterprises at a "good price" to the large business house and foreign capital. It also required closing down of a large number of the so called "sick public enterprises", and with the advent of liberalization or free trade there is free entry of foreign capital, major reforms in banking, financial institutions and the tax structure.¹⁰ Thus India adopted World Bank inspired Structural Adjustment Policies (SAP), which insists on policy privatization.

Privatization policy is essentially a process of creating dualism in the economy, giving rise to the skewed distribution of the resources and ownership of the means of production. This in turn goes against the very spirit of Part IV of the Constitution. The point to be noticed is that if the social justice concerns are abandoned, there is danger not only to Part IV of the Constitution but equally great danger to Part III¹¹. Supreme Court decision in Tara Chand Vyas v. Chairman & Disciplinary Authority,¹² substantiates the above proposition. Court in this case held that economic empowerment is the fundamental right of weaker sections of society¹³. It is to be remembered that, if privatization policy is implemented without adequate protection to the weaker sections, that will be against the constitutional obligations.

It would be appropriate at this juncture to point out the reasons for nationalization in banking and insurance sectors, which can be summed up in the following words:

"Though there was economic development in the country, the fruits of economic progress are not shared equally. It flows into the pockets of traders, businessmen and industrialists. This will be against the principle of social justice."¹⁴

In Muir Mills Ltd V. Suti Mill Mazdoor Union¹⁵, the Supreme Court regarded social justice as the living concept of revolutionary import. According to the Court, it gives sustenance to the rule of law and meaning and significance to the ideal of a welfare state¹⁶. One of the functions of a welfare state is nationalization of industries.¹⁷

C.E.M. Joad has best explained the aim of nationalization in the following words:

"The mass of wealth thus acquired by the state is to be used for the provision of national education, for the maintenance of a high national minimum wage, for the care of the sick and infirm, for the endowment of maternity, for the encouragement of scientific research, and for the rising of general standards of life of the community"¹⁸.

Bombay High Court once observed that,¹⁹ "Banking undoubtedly is an activity vital to the life of the community and it is undoubtedly a business of great public importance". After independence, major reform in banking sector came with the enactment of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1969. The purpose was to nationalize fourteen banks. The Act was challenged in the Supreme Court.²⁰ Petitioner in that case claimed a declaration that the Act impairs his rights guaranteed under Articles 14, 19 and 31 of the Constitution and is on that account invalid. The special Bench of 11 judges decided the petition on 10^th February 1970. The court by a majority of 10 to 1 held that although the Act was with in the legislative competence of the Parliament, it was void for the following reasons: -

1. The Act prohibited the fourteen banking companies from carrying on banking business, where as other Banks, Indian and foreign, were permitted to carry on banking business. This was a hostile discrimination.
2. Although the fourteen banking companies would carry on any other business, since they were stripped of their assets, staff, premises and even names, it was impossible for them to carry on any other business. This was an unreasonable restriction.
3. The principles adopted for determining the compensation to the 14 banking companies were illusory and irrelevant.

The Supreme Court changed its attitude to nationalization in subsequent decisions. In All India Bank Officers Confederation case, the court held that, the object of nationalization of banks is to render the largest good to the largest number of people.²¹ The court also observed that employees and officers working in the banks are not merely trustees of the society but bear responsibility and owe duty to the society for effectuation of socio-economic empowerment.

Judiciary not only interfered in the policy decisions of the bank,²² but also criticized the casual manner in which banks are functioning.²³

In P. C. B. Houses v. United Commercial Bank & Others,²⁴ the Court held that loan by nationalized bank to small scale entrepreneur should not be circumscribed by considerations of commercial profit. Court castigated the conduct of the bank as reprehensible for having transferred Rs. 12.95 lakhs by the Board to the account of another person on oral transaction. Such functioning of a nationalized bank is detriment to public interest.

The recommendations of the First Narsimham Committee on Financial System (CFS) are all directed towards reversing the direction which banking policy has so far taken. Though the committee has not openly come out in favour of bank privatization, it suggested everything that would be appropriate for a market driven and profit seeking private bank. According to the words of the Committee:

"Committee believes that consistent with the other aspects of government policy dealing with foreign investment, the policy with regard to allowing foreign banks to open offices in India should be more liberal subject to the statutory requirements of reciprocity and the maintenance of such minimum assigned capital as may be prescribed by the Reserve bank. The entry of foreign banks into the country, we believe, would have a beneficial impact from the point of view of improving competitive efficiency of Indian banking system as also upgrading work technology"²⁵

The Committee on Banking Sector Reforms (BSR) recommended the second dose of banking reforms in April 1998. Narasimham was the chairman of this Committee also. The main theme of the Second Narasimham Committee report is that strengthening the banking system is critical to the growth of the economy and this would require tightening capital adequacy, income generation and provisioning norms over the next four years. The Committee recommends further that the minimum shareholding by Government/Reserve Bank of India in the equity of nationalized banks and SBI be brought down from 51% to 33%²⁶. Unlike the other one, this Committee openly comes out in favour of bank privatization.

The Verma Committee report of 1998 on the other hand recommends closing down weak banks. According to the Verma Committee, weak banks are those banks, which have high non-performing assets. The Committee found that many of the rural branches have high non-performing assets and considered those banks as weak banks. If the weak banks are allowed to function in the economy it will affect the efficiency of other banks also.

Thus it is clear that all these committees consider that banking sector should be restructured to bring efficiency to it. The Government has taken many measures to implement the recommendations of the committee.

The new banking culture nurtured by reforms, is reflected in shunning the lending to priority sectors, fully exploiting opportunities offered by capital market related activities, a nose-dive for making an easy and quick ‘kill’ in terms of profits, making use of finance companies in preference to direct lending. As the Chairman of the State Bank of India rightly pointed out, "this approach betrays an innocence of Indian economic realities".²⁷ The most conspicuous feature of the ‘new culture’ bred by reforms is the willful neglect of weaker sections. These reforms would bring following changes:

(a) PRIORITY SECTOR LENDING

There is a general perception that the prescription of 40 percent of the net bank credit to priority sectors, have led to higher level of Non Performing Assets²⁸ (NPAs), due to credit to these sectors becoming sticky.²⁹

The report on Trend and Progress on Banking in India 1996-97 states that priority sector advance accounted for 47 per cent of the total NPAs.³⁰ The higher proportion of NPAs in priority sector advances was due to the following reasons. (a) The directed and pre-approved nature of loans sanctioned under sponsored programmes, (b) Absence of any security, (c) Lack of effective follow-up due to large number of accounts, (d) Legal recovery measures being considered not cost effective, and (e) vitiation of repayment culture consequent to loan waiver schemes.³¹

Whatever may be the reason, it is an accepted fact that, increase in the ‘non-performing assets’ of the banks will definitely affect the health of the banking system. Naturally this issue became a concern for both Narasimham Committees. In 1991, Narasimham had recommended that the percentage of aggregate credit to a priority sector should be reduced from 40 to 10 percent. The Government did not accept this recommendation in the face of all-round stiff opposition.

Two other committee reports, submitted during the same period, had targeted for attacking the concept of priority sector lending and agricultural advances. The Gupta committee on Agricultural Credit³² is for excluding the criterion that ‘18 per cent of the total bank credit should be for agricultural sector.’ The Khan Committee on the other hand recommends for redefining priority sector so as to include large infrastructural advances in priority sector advances. Since the former is for large amount, these advances will occupy major portion of priority sector advances. For this reason, when calculating the percentage of priority sector advances in total bank credit, large infrastructural advances given under priority sector advances should be excluded.³³

Recommendations of all these committees are for deteriorating the priority sector lending. As a result of these recommendations the share of priority sectors in total net bank credit declined consistently from 40.9 per cent in June 1991 to 39.3 per cent in June 1992 and further 35.9 per cent in June 1993. The interesting thing is that, target for priority sectors remained unchanged at 40 per cent even after this. The Reserve Bank of India appears to have chosen to wink at the default³⁴. Thus, there is a conscious neglect of priority sectors.

(b) NO MORE SUBSIDIZED INTEREST

The basic thrust of the Narsimham Committee is that real interest rate should be positive and the concessive interest rates should not be the vehicle for subversion. As a result, even a small borrower today has to pay an interest rate of 12.5 per cent as against 10 per cent earlier.³⁵ As far as an agriculturist is concerned this recommendation is the last straw.

In the estimation of the National Credit Council, the various institutional credit agencies like cooperative, commercial and RRB’s met only 38% of the estimated credit requirements of agriculture in 1976-78. There have been only marginal improvements in this position.³⁶ According to the Khusro Committee Report, total term credit requirement for 1999 – 2000 is Rs. 7595 crores³⁷.

This shows that, institutional credit supply is inadequate. This coupled with absence of subsidy in interest rates will affect the agricultural sector, create food scarcity, and effect the human rights.

(c) IMPACT ON AGRICULTURE

As far as India is concerned, agriculture forms the backbone of our economy to such an extent that 59.4 per cent of the working population is engaged in agriculture. However, this sector suffers from lower productivity per hectare and per worker. One of the main factors responsible for this backwardness in agriculture is inadequate non-farm service like finance and marketing. As regards finance, the credit requirement of agriculture sector is so large that to meet even a part of this requirement, Indian banking will have to strive hard. Likewise, small-scale industries are also important for national economy in terms of their contribution to growth, employment generation and broadening the base of income distribution. These sections are elevated to the status of priority sectors because they are financially and socially backward.

Information provided by the Reserve Bank of India, on recovery performance of direct agricultural advances, clearly shows that it has been improving. According to the data provided by the RBI, recovery performance of direct agricultural advances increased from 54.1 per cent in 1992 to 59.6 percent in 1995³⁸. The policies initiated by the RBI on the issue of treating agricultural advances, as NPAs should be viewed against this backdrop.³⁹

It is a fact that, though the target for priority sector remains unchanged at 40 per cent, the share of priority sector in total net bank credit is declining and the RBI has maintained a studied silence on the default. A disturbing aspect of this default is that such decline has occurred in spite of the fact that the ‘norm’ of priority sector credit has been diluted substantially. For instance, direct and indirect advances to agriculture can now be clubbed for meeting the sub target of 18 per cent of direct advances to agriculture. The definition of priority sector itself is widened: advances up to Rs. 5 Lakhs for financing the distribution of inputs for agriculture and ‘allied’ sectors can now be considered as indirect advances to agriculture. The ‘allied’ activities include dairy, poultry, and piggery and consequently advances for poultry feed and cattle feed are eligible for being included under this category.⁴⁰ Moreover, the share of agricultural advances in total net bank credit declined consistently to 16.4 per cent and further to 14.3 per cent during the period of 1991–96.⁴¹ Thus, it is evident that the reduction in priority advances will certainly have impact on agriculture.

(d) REGIONAL IMBALANCES

In its report in 1991 and in 1998, Narasimham Committee suggested abandonment of branch licensing. The Committee said:

"It was perhaps desirable and necessary for extending geographical spread in the formative years of expanding the financial infrastructure…[it now] needs to be reviewed… with the banking system now having extended its branch network over a vast area of rural hinterland and successfully achieved an increase in banking density…branch licensing be abolished."⁴²

The Committee also observed:

"Indian experience has shown that asset quality has suffered as a result of directed credit. Directed credit, apart from leading to possible misapplication of credit resources, has led in this country, as elsewhere, to an increase in non-performing loans"⁴³.

As per the Verma Committee Report such banks should be closed. The implementation of this recommendation will result in closure of most of the branches in rural area. For, many of them incur losses on account of low yielding advances unfavorable deposit mix, lack of scope of non-fund business or for augmenting non-interest income, high establishment cost and inability to improve business levels substantially.⁴⁴ The closure of rural branches in turn will result in regional imbalances, the removal of which is one the objects of nationalization of banks.

Liberalization of licensing policy also will create regional imbalances. In terms of Section 22 of the Banking Regulation Act, 1949 every company is required to obtain a license from the Reserve Bank before commencing banking business in India. A license may be issued subject to such conditions, as the Reserve Bank may think fit to enforce. The provision for licensing has been used by the Reserve Bank as a method for improving the working of individual banks, rather than as a mere restrictive measure.⁴⁵

Following the recommendation of the Narasimham Committee, bank branch licensing policy was deregulated. The Reserve Bank of India has permitted banks attaining capital adequacy norms and prudential accounting standards to set up new branches without its prior approval.⁴⁶

Moreover it now provides operational autonomy to banks to rationalize their branch network. Banks are free to shift their existing branches within the same locality and open certain type of specialized branches (specializing in agriculture and small-scale industry finance). They can also convert existing non-viable rural branches into satellite offices, and close (with the approval of the Reserve Bank) one loss making rural branch at rural centers served by two commercial banks by mutual consent.⁴⁷

The effect will be that new banks entering the field will not open branches in rural areas. High fixed costs of establishing financial intermediaries coupled with relatively low demand for banking services in rural area make it unprofitable for private agents to open branches in these areas.⁴⁸ Even if one set up rural branch, interest rate will be high. Now the condition will be that there will be private banks with exorbitant rates of interest. There will not be any more lending to socially desired goals. Rural credit will not be available. Thus a small borrower will be in the pre-nationalization period.

(e) REDUCTION IN SLR – CRR RATIO

It is with a view to augment the lendable resources of banks to enable them to meet the genuine production requirements for credit, without generating excessive monetary expansion, that decision to reduce CRR has been taken. Accordingly it was reduced by one percentage point from 14% to 13% in two phases of 0.5 point each.⁴⁹

The reduction in CRR would augment the lendable resources of banks by about Rs. 3,80,000 crores and also significantly improve the profitability of banks. It is pertinent to note that the effective CRR for the system has been brought down from 15.7% at the end of March 1995 to 13.8 % at the end of March 1996 with measure announced recently, the effective CRR for the system would be a little over 12.5% SLR has been brought down significantly from 38.5% to 30% for increases in net demand and time liabilities from April 3, 1992 onwards. But the banks, to engage freely in speculative transactions, with the sole purpose of maximizing their profits will use the reduction in SLR – CRR.⁵⁰

(f) INCOMPATIBLE WITH SMALL BORROWERS

Profitability has emerged as the single most important criterion for judging the operational efficiency of individual banks. This is another feature of new banking culture. A result of these banks is finding increasingly convenient to lend in bulk to non-banking financial companies (NBFC), than to small-scale industries and micro business. The latter in fact are being pushed into the arms of NBFC, which charge lending rates of 25 per cent or even more.⁵¹

To some extent, these are an extension of the worldwide phenomenon of the blurring of the distinction between commercial banking and participation in capital market transactions by financial institutions – a blurring of the distinction between short – term and long –term lending. It is possible to argue that properly guided and controlled, this by itself would not be unsuitable to a developing economy. When it is said that banks and other financial institutions should support development, it in part want banks to lend for financing fixed capital investment. But the difference lies in what kind of investments is supported. Under new dispensation, such support is to be extended, not to "public investment" but to private investment, geared to the most "profitable" rather than the most "essential" uses of domestic savings.⁵²

Moreover, public sector banks, imitating foreign banks, insist upon a large minimum balance to be maintained by savings bank account holders. This is yet another fall-out of the market mythology. This is a retrograde step in a system where public sector banks could take legitimate pride in helping to raise Indian saving rate to a respectable level.

(g) BACK TO NATIONALIZATION ERA

Performing the role of a disinvestments commission in respect of the banking sector, the Narasimham Committee suggests that the "shareholding by government/Reserve Bank in the equity of the nationalized banks and the State Bank should be brought down to 33 per cent". Dilution of government state in nationalized banks will eventually result in the control of these banks by private enterprise, as was the case in the pre-nationalization era.

(h) UNEMPLOYMENT

Report of the Committee on Financial System observed that Indian Public sector banks are "over regulated and over administered". A central concern is the flexibility for banking operations, which is absolutely essential to respond to changing conditions. Subsequent to nationalization employment in the banking industry has grown very significantly. This is partly due to branch expansion and partly because of diversification of banking services. The enormous increase in business and the inadequacy of traditional banking procedures have strengthened the case for computerization of banks. Naturally, the proposal to close down unviable public sector units has come in for strong opposition.

Banks play an important part in the economic progress of the country. Public funds are involved in the banking and insurance sectors. Both these collect the surplus money from the society and channelize it in the socially desired directions. Any malfunctioning in these sectors may be detrimental to society as well as to the individual.

Moreover, with the Indian constitutional mandate, Indian economic activity has to satisfy the demands of distributive justice and public interest⁵³. But in the process of privatization, casuality is often public interest. This is because privatization has created some improper behavior in human beings. Illegal aptitude for money is the main cause of corruption, which is possible in the fully free and market oriented economy.

Indian masses are affected by privatization in banking and insurance sectors. The argument raised is that, privatization will not be able to safeguard public money and win over public confidence. Moreover, money will be utilized for certain people and certain industries only. Another point is that profit will not be channelized usefully. It is doubtful obligation of equitable distribution of wealth.

There are at present 28 commercial banks in the public sector. They account for more than 90 per cent of total deposits and advance and also provide short-term credit.⁵⁴ Over the year commercial banks have diversified into several new areas of business like merchant banking, equipment leasing, mutual funds, venture capital, housing finance and factoring services. Besides, there is a wide network of co-operative banks for the provision of short-term credit to co-operatives and land development banks.

Public sector banks have achieved major goals of nationalization. These banks have grown significantly. There are certain shortcomings in the nationalized sector, like deterioration in the quality of credit portfolio of banks, substantial amount of non-performing assets and inadequate recovery of claims. But this should not lead to a doubt the success of nationalization of banking structure in implementing the human rights values. It is true that only a portion of weaker section was able to reap the benefit of bank nationalization. Is there a remedy for the protection of weaker section with in nationalized sector?

One solution will be to retain nationalized sector and to make the working of the Debt Recovery Tribunal effective and powerful. The Supreme Court in a recent case⁵⁵ held that the Tribunal can go beyond the Civil Procedure Code and the only check put on its power is to observe the principles of natural justice. Another solution will be to take adequate security before granting loan. Gujarat High Court in State Financial Corporation v. Lotus Hotel Pvt., Ltd.,⁵⁶ held that repaying capacity of the borrowers and security of the money are the only factors to be considered by banks on giving loans. Banks have full discretion to decide on the matters of loan.⁵⁷ The Government and Reserve bank of India regulations are guidelines only.

In the case of privatization, banking industry will be dominated by a handful of big industrialists. Such ownership pattern in a critical industry such as banking would not be consistent with the nation’s social and development objectives.⁵⁸ Altogether the direction which the government wants to give to banking policy, is not just disturbing but clearly adverse to development and equity. Thus it can be seen that the new banking culture is alienating not only the small borrower but also the small saver. This is against the objective of nationalization and also against constitutional obligation of equitable distribution of wealth.