Bank nationalization stands the test of time
There is an uncanny resemblance between the announcement of withdrawal of legal tender character of specified bank notes (known as demonietization or notebandi) in 2016 and the acquisition and transfer of banking companies (known as bank nationalization) in 1969. Both were announced in a special address around the same time—8.15pm for demonetization and 8.30pm for bank nationalization. That’s where the similarity ends.
While the timing of the announcement of bank nationalization 50 years ago was indeed a surprise, the aspect of “social control” over banks and other financial sector institutions were being discussed in the 1960s. The Imperial Bank of India had already been nationalized and was renamed as State Bank of India (SBI). The other banks of the princely states were acquired by SBI much earlier. However, the nationalization of banks in 1969 and later in 1980 was of a completely different scale. In 1969, the move covered 14 (followed by six in 1980) of the largest private sector banks—putting 85% of the deposit base into the hands of the government.
It is impossible to look at the counterfactuals on how the banking system would have looked without nationalization. While 13 of the “old generation private sector banks” continue to exist, they have not had much impact on the banking system. The new generation private sector banks established around 1994 are fewer in number, and have a shorter history—they have done much better both in terms of their reach and business.
Goal of social control
The objective of social control was about making banking sector accessible in areas where these services were not accessible. Bank nationalization was not the only tool used. Prior to nationalization there was a decade of state partnership with cooperatives which helped in taking the number of village-level agricultural credit cooperatives to almost 100,000 in number. The state also established 196 Regional Rural Banks (RRBs) between two nationalizations. Therefore nationalization should be seen as only one (significant) step in several initiatives taken by the state. While nationalization gave access to the commercial banking system, the objective of social control was achieved through two significant policy initiatives: branch licensing and priority sector lending requirements.
Branch licensing policy certainly increased the spread of commercial banks in rural areas. The policy initiative was to grant a licence for opening a branch in an urban/metropolitan location only if the bank opened four branches in the unbanked rural locations, famously called as the 1:4 licensing policy. This addressed the spatial issue and possibly achieved the intended impact on poverty and inclusiveness, corroborated by a well-regarded study by Robin Burgess and Rohini Pande. They have argued that 1:4 licensing policy had an impact on reduction of rural poverty. Interestingly, they also argue that opening more branches did not have any impact on urban poverty.
The priority sector lending targets allocated to banks achieved sectoral allocations like agriculture and small industries. So, 40% of the bank credit had to flow to these sectors, with agriculture having hard sub-sectoral target with penal clauses.
However, there is a bit more nuance. While nationalization, branch licensing policy and priority sector lending targets helped the banks to go to rural areas and certain sectors, it did not achieve regional balance. Of the 20 banks that were nationalized, seven were concentrated in south India, six in west India, four in north India and three in east India. The expanded rural branch network followed the extant regional concentration, bringing more intensive banking in southern and western regions. The central belt and the north-eastern states significantly lagged in getting banking even after nationalization.
This skew was partially set right by two initiatives. The first was an institutional intervention of opening 196 RRBs which had focused area of operation. The RRBs contributed significantly to reduce the regional imbalance with their expanding branch network in the 1980s. RRBs also had a greater proportion of their loans flowing to priority sector in general and agriculture in particular. The second was the policy on lead bank scheme where one bank was assigned as a lead for each district. The lead bank was responsible for the growth and penetration of banking in districts and had to achieve it in coordination with other banks and the state machinery. A “district credit” plan (euphemism for a banking plan), dovetailed with the government schemes, was to be prepared and monitored by the lead bank.
Importance of state control
So, branch licensing and lead bank assignment could not have by themselves achieved the social objectives of the state. Having ownership and operational control of the banks was equally important. Obviously, the banks were constantly challenged on their profitability parameters—particularly RRBs which had both geographical and portfolio concentration risks. Since they were state-owned, it was possible to have backstopping arrangements of recapitalization through budgetary allocations sporadically when needed.
Here are two more pieces of evidence. When first set of new private sector banks were set up in 1994, the state did away with the branch licensing policy, while continuing the priority sector lending targets. This decade saw the growth of banking in urban areas and contraction in rural branches including those of RRBs. This is the comparative data used by the Pande and Burgess study to establish the criticality of branch licensing policy. This shows that irrespective of ownership, the policy was necessary.
Then, examine the Pradhan Mantri Jan Dhan Yojana accounts. Of the new accounts 77% were opened by state-owned banks, 20% by RRBs, and a mere 3.4% accounts were opened by private banks. This indicates that ownership with operational control matters when the policy push doesn’t have teeth.
Public versus Private
A look at the broad performance ratios for 2017-18 (see table)shows that private sector banks score better on efficiency and profitability parameters—they have better return on assets, return on equity, net interest margin and a higher proportion of low-cost deposits. On the other hand, public sector banks (PSBs) have a better impact on priority sector lending achievement, and paid higher wages.
The hindsight of 50 years tells us that it was critical to have ownership and operational control of the banking system to deliver the larger inclusion agenda. However, other structural, institutional and policy measures were also taken. From this perspective bank nationalization was indeed a good move at that time.
In the decades post liberalization, the state has refrained from pushing state-owned institutional structures—except for the failed Bharatiya Mahila Bank. Instead, the policy has leveraged existing structures to deliver more effectively—continuing the branch licensing but at 25% of new branches rather than the 1:4 rule; holding on to both the priority sector lending targets (and even making it more stringent and applicable to foreign banks with a footprint); and the lead bank scheme. Steps have been in extending banking services through alternative mechanisms (banking correspondents, redefining branches and so on). The state has also provided benign policy architecture for innovations and has allowed microfinance institutions (MFIs) and newer niche banks in the private sector to scale up. Has this changed the picture?
The banks in general have taken savings away from rural areas, where the credit deployment is 58% of the deposits collected, as against a credit deployment of 95% of the deposits collected in metropolitan areas. RRBs and PSBs have also been taking more savings from rural areas—deploying only 53% of the deposits collected in rural areas as compared to 96% of the deposits collected deployed in urban/metropolitan locations. The state-owned banks have more slack and they have not effectively deployed financial resources.
RRBs are a shade better when it comes to rural lending. While they have deployed 72% of the rural and semi-urban deposits as credit in those areas, the figure for urban understandably is very low, and most of these funds have gone into investments. Private sector banks have done much better by deploying almost 80% of the deposits they have picked up in rural and semi-urban areas. This they deployed through interesting intermediation mechanisms and portfolio purchases by using entities, with feet on the ground like MFIs. They have a better record of overall deployment of credit in non-rural areas as well.
The new small finance banks (SFBs) give an entirely different picture—a large number of them are MFIs that converted into banks. Their natural book on the assets side was made up of small loans to a large number of people and also in rural areas. These institutions are trying to collect deposits from the middle and upper middle class and deploy those resources towards the poor.
From a paradigm point of view, possibly SFBs are the most interesting institutions that have turned the tables and are trying to achieve from the private sector the objectives set out in the bank nationalization. However, would they continue to stick to this model? We have to wait and watch. From early indications it appears that the results are going to be mixed.
In a recent article in Bloomberg Quint, Y.V. Reddy, former governor of the Reserve Bank of India said, “Banks were nationalized at the whim of a prime minister, they will be denationalized at the whim of another prime minister.” So, are we now ready to take the next whimsical step of denationalizing the banks?
As things stand, RRBs are being consolidated in an attempt to move them closer to market-based solutions. The cooperatives are shrinking. PSBs are up for consolidation. From the larger perspective of efficiency and better utilization of capital, it may be a good idea to move state-owned banks towards more market-based framework. However, that call should be taken after having a roadmap to achieve the residual task of inclusion.
The All India Debt and Investment Survey reports indicate that the formal sector has been losing ground to the informal sector in the rural indebtedness pie since 2001 onwards. This is worrying and indicates that the inclusion agenda is far from achieved.
Some examples in the public sector banking system—particularly SBI—have shown that it is possible to achieve the double bottom line of being in the commercial market while continuing to achieve significant targets in inclusion, sectoral, spatial and geographical. With relative autonomy, and a tight policy it is possible for state-owned banks to deliver profits. And, given the work that remains, there is no ready answer to whether this is the time for denationalization. Making state-owned banks more autonomous and accountable to the market may be the first significant step that can be taken for now.