New Delhi: The Narendra Modi government’s reform of public sector banks in the last six years is a “still-born effort”, said a new research paper jointly authored by former Reserve Bank of India (RBI) deputy governor Viral Acharya and former RBI governor Raghuram Rajan.

The duo suggested a slew of reforms, including greater operational independence for state-run banks, gradual reduction in government’s stake below 50 per cent and reprivatisation of some select banks to begin with, in the paper released 21 September and available on the website of University of Chicago Booth School of Business.

The paper warned that the pandemic will sharply increase the loan losses in the system and it may be greater than what the government can afford to pay.

“With government deficits and debt levels reaching enormous levels, there simply are not enough budgetary resources to recapitalize banks. An encumbered, under-capitalized public sector banking system will not lend well, which will be a huge tax on growth, as it has been for the last six years,” the paper said.

“More worrisome, without reform the banks will accumulate further losses. Status quo is simply not an option,” it added.

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The authors also stressed that for banking to become an engine of growth, incremental reforms are not enough.

“With the enormous strains on government finances from the slow growth pre-COVID and the subsequent effects of the pandemic, the country has to transform the banking sector from being a drain on government resources and an impediment to growth to becoming an engine of growth. This will not happen through incremental reforms. The status quo is fiscally untenable,” the paper said.

Acharya was RBI deputy governor between 2017 and 2019. He quit ahead of the completion of his term in July last year. Rajan led the central bank between 2013 and 2016.

‘Little incentive to loosen grip’
The paper pointed out that despite Prime Minister Narendra Modi’s backing for reforms in state-run banks, including appointing the Banks Board Bureau to decide key appointments, there has been hardly any progress in the last few years.

“The final decision as well as allocation of selected CEOs to banks is still with the government. The Department of Financial Services still appoints bank board members and decides on important strategies such as mergers,” the paper noted.

It added that it is unfair to only blame the bureaucracy as the government in power has “little incentive to loosen its grip on public sector banks”.

The former central bankers pointed out that the government obtains enormous power from directing bank lending, including the power to exercise control over industrialists.

Citing the example of electoral bonds, the paper pointed out that the government gets access to sensitive information through its state ownership as with the identity of purchasers of electoral bonds, which is known only to the State Bank of India.

Citing the example of electoral bonds, the paper pointed out that the government gets access to sensitive information through its state ownership as with the identity of purchasers of electoral bonds, which is known only to the State Bank of India.

More independence to banks, abolishing financial services dept
Acharya and Rajan’s paper suggested several measures to improve the performance of state-run banks but noted that many of them have been made by committees like the Narasimham and the P.J. Nayak panels.

It called for improving the operational performance of state-run banks through a holding company structure for government banks. It added that the government should pay the state-run banks for costs incurred to meet its goals like opening branches in remote rural areas.

The paper also suggested doing away with the Department of Financial Services (DFS). DFS is one of the five departments in the Ministry of Finance overseeing state-run banks. It also advocated incentives for senior management and longer terms for bank chiefs.

State-linked banks and not state-owned

The paper recommended gradually reducing the government’s stake in public sector banks, first beginning with reducing the stake below 50 per cent. It added that reprivatisation of select PSBs can be looked into along with automatic dilution of government stakes.

“Our proposals, taken together, will move the needle significantly on Indian banking. They are not, however, revolutionary… There are strong interests against change, which is why many would-be reformers are cynical… We are more optimistic that a middle road is achievable, given that the greatest stumbling block has been the government, the bureaucracy, and the interests within it.”