Public Sector Banks — From Inception to Recent Reforms

The Big Bang — Nationalisation of Banks in 1969

Our story starts 52 years ago, on 19th July 1969.¹ The then prime minister of India, Smt. Indira Gandhi, announced the nationalisation of 14 private banks via a radio broadcast (Ramesh, 2019), marking the beginning of substantial government control over the country’s banking system.

The government’s decision led to flurry of legal and legislative activity, beginning with Shri. Rustom Cavasjee Cooper’s² petition at the Honourable Supreme Court of India (1970 AIR 564, 1970 SCR (3) 530). The petition challenged the government’s move claiming (among other concerns) that it placed unreasonable restrictions on the right to property of the shareholders.

Article 31(2) of the constitution, in essence, stated that the Court cannot call into question any law that enables the compulsory acquisition of property for which a compensation amount/mechanism is specified, on grounds that the compensation provided is not adequate. The Apex Court however noted that the right to compensation was a constitutional guarantee (enshrined in article 19(1)(f)), meaning that the Court could delve into the question of whether the compensation provided by the government reasonably settles the loss of property suffered by the shareholders of the banks to be nationalized.³ The Court hence ruled that the government under article 31(2) would have to compensate the monetary equivalent of the property (i.e. shares) acquired (Singhal, 1995).

In the wake of the Apex Court’s judgement, a fresh compensation scheme was promulgated under the ‘Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, 1970’ on February 14th 1970. The ordinance was later enacted by the parliament as ‘The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970’ in March 1970. The policy costed the then government around ₹3,504 crores (inflation adjusted figure in 2020 rupees), which was paid over three instalments. This was a staggering 7.48% of India’s gross domestic product (GDP) in 1970.⁴

Further, to avoid compulsory acquisitions from being paired with the right to compensation, the parliament amended the constitution (The Constitution (Twenty-Fifth Amendment) Act, 1971), wherein the word ‘compensation’ in article 31(2) was replaced with ‘amount’.⁵ The nationalisation of banks in 1969 was one of the situations where a purported ‘economic’ policy had serious constitutional ramifications, almost enabling the government to acquire private property without providing just compensation.

There was another round of nationalisation in 1980. The parliament enacted ‘The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980’ on the 11th of July 1980. Six banks were nationalised at a cost of ₹350 crores (inflation adjusted figure in 2020 rupees), which was around 0.2% of India’s GDP in 1980.

This episode in India’s economic history is relevant today insofar as raising fundamental normative questions about the right to property and the extent to which the government can go for a perceived ‘social good’.⁶ Having said that, debates about the merits and demerits of nationalisation and whether it should have been done are of very little utility. Such debates often revolve around endless arguments over the various possible counterfactuals, adding little to no value, as one could always find suitable counterfactuals to either validate or invalidate the policy.⁷

The 1990’s — Liberalisation and Banking Reforms

The 1990’s saw the liberalisation of the Indian economy under prime minister Shri. P.V. Narasimha Rao. Panagariya (2005) identifies three major economic policy reforms that defined the 1990’s, namely, (1) deregulation of industry (which did away with the plethora of licenses and approvals required to start a business or for making foreign direct investment), (2) strengthening external trade (import tariff reductions and customs reform), and (3) the liberalisation of trade in services (specifically the opening up of the telecommunications sector).

In addition to the reforms in the industry, the scope for reforms in the banking sector was also thoroughly explored. The then government constituted the (first) Narasimham Committee to provide recommendations for reforming the financial system to ensure that it can sustain the structural economic reforms that were conducted then (Narasimham et al, 1991).

The (first) Narasimham committee was a first of its kind, and took a fresh look at India’s financial sector at large. One of the most important aspects of the report were its recommendations for improving the asset quality, profitability, and corporate governance of banks.

A crucial wakeup call was given by the report as it highlighted the issue of capital inadequacy in the banking system. Most notably, the report encouraged profitable banks to directly raise capital from the market, while it advocated capital infusion by the government for the poorly performing banks. The committee also recommended improving the transparency of banks’ balance sheets by adopting the guidelines laid down by the International Accounting Standards Committee (IASC). Further, the committee recommended the setting up of special tribunals to hasten recovery of loans and proposed the formation of ‘Asset Reconstruction Fund’ to buy doubtful/bad debts from the banks and clean up the banks’ balance sheets, while providing the fund with special powers for the recovery of bad debt. Finally, the committee recommended the amalgamation of banks via mergers and acquisitions, to limit the number of large banks with international operations to four and the number of pan-India national banks to just 10.⁸

In terms of operations, the report advocated for greater autonomy of banks, and for the computerisation of core processes. In specific, the committee called for an end to ‘dual control’, where the Reserve Bank of India (RBI) and the Banking Division of the Ministry of Finance had supervisory and regulatory control over nationalised banks, under the 1970 and 1980 bank nationalisation acts. The committee recognised that the supervision and regulation of the government extended to aspects that were not associated with the compliance of prudential norms ensuring asset quality, and were more in the realm of granular operations and management. The committee called for the involvement of the government to cease and be left to the RBI. The committee further suggested a quasi-autonomous body under the aegis of RBI to perform the supervisory functions, as the RBI department performing the supervisory role was already overburdened.⁹ This recommendation has still not been implemented despite being raised repeatedly by former RBI governors such as Shri. Y V Reddy (Acharya, 2018) and Shri. Urjit Patel (Mint, 2018).¹⁰

The recommendations were revisited by another committee under Shri. M. Narasimham¹¹ (Narasimham-II committee) in 1998.¹² The committee provided certain additional prudential norms such as the 90 days norm¹³ for recognition of Non-Performing Assets (NPAs), which is currently in practice. Currently, an asset is flagged as an NPA if interest payments/installments of principal are not paid within 90 days since the due date. Further, the committee stressed the need for operational restructuring to accompany the cleaning up of the bank’s balance sheets and the requirement to incorporate technological improvements in banking, specifically in the realm of information technology (Narasimham et al, 1998).

The Narasimham committee reports were truly forward looking, with some of its recommendations, such as the amalgamation of banks, being implemented only recently.¹⁴ The recommendations were significant in that it reflected a paradigm shift in the policy outlook, in fact the committee suggested the government to announce that there shall be no further nationalisation of banks and to remove the barriers to entry for new private sector banks. Welcoming private sector banks, as long as they maintained the necessary capital and adhered to the prudential norms, was indeed a tectonic shift in economic thinking in India.

The Age of Globalisation and The Modern NPA Debacle

The late 1990s and 2000s were marked by rapid globalisation of economies around the world and increased economic interconnectedness. This meant that while economies grew together, they also fell together owing to the spill-over effects.

India’s story starts in August 2008. The RBI laid down certain special regulatory treatment for restructured assets¹⁵ to retain their status as ‘standard’ (i.e. non-NPA) assets. Assets were permitted to retain their ‘standard’ status if the dues (both principal and interest) post restructuring were fully secured with a tangible security and if the asset had not been restructured in the past.¹⁶

In a later circular¹⁷ in January 2009, the RBI relaxed the requirements for this retention of ‘standard’ status owing to stresses created by the economic downturn post the 2007 financial crisis. The RBI noted that the drawing power¹⁸ of businesses decreased substantially due to the fall in prices of the securities pledged. This led to an increased requirement for converting the irregular portion¹⁹ of the outstanding advances into working capital term loans (WCTL) during restructuring. Given the economic condition, many debtors were unable to provide securities to fully secure the WCTLs. The RBI hence relaxed the need for full security cover for WCTL in restructured assets, and instead required provisions worth 20% of the unsecured portion of the WCTL to be provided for by the bank. This relaxation was made available till June 2009. The ‘Restructured Standard Assets’ (RSA), as they were called, soon became a safe haven for poor quality loans, which remained hidden under the ‘standard’ tag (Tripathi et al, 2019). Figure 1 shows the steep increase in RSAs since 2009, peaking at close to 7.78% of the gross advances in March 2015.

Steps were taken to mitigate the growing crisis since 2015, specifically with measures such as the Asset Quality Review (AQR)²⁰ to ascertain the quality of the public sector bank’s balance sheets and to clean them up. This meant that the consequent capital erosion would have to be replenished with fresh infusion of capital (see project Indradhanush²¹), coupled with technology enabled risk management reforms and improving corporate governance (see Banks Board Bureau²²). The total recapitalisation of public sector banks (PSBs) stood at a staggering ₹2,16,072 crores between 2014 and 2021.

The successive waves of government capital infusion have substantially increased the government’s stake in PSBs as evidenced in Table 4.

With the asset quality issue under control (to an extent), the government pushed for operational reforms in 2018–2019. The Indian Bank’s Association launched the ‘EASE (Enhanced Access and Service Excellence) reforms agenda’. EASE had two major themes namely, ‘CLEAN’²⁷ banks and ‘SMART’ banks.²⁸ The ‘CLEAN’ banks theme focused on improving lending practices, while the latter dealt with improving customer service and business reach (Tripathi et al, 2019). Further, over 140 metrics²⁹ were identified to track the performance of banks across a multitude of dimensions from standard prudential aspects such as asset quality and profitability to business specific aspects such as customer satisfaction and human resource management (Tripathi et al, 2019). The health of PSBs is a very crucial element for the growth of the Indian economy as PSBs hold over 65% of the deposits and 60% of the loans/advances in India, as of 2020. (RBI, 2021)

The Evolution of Public Sector Banks since 2015–16

Now that we have explored the story of how PSB’s came into existence and the reforms over the past few decades, it is time to explore how the PSBs performed, specifically since the barrage of reforms starting with the AQR in 2015–16. We do so by looking at the evolution of seven key metrics that capture capital adequacy, asset quality, and profitability.

Capital Adequacy Ratio

The capital adequacy of banks briefly fell between 2017 and 2018 (when the balance sheets were being aggressively cleaned), however the CAR ratios have emerged back strongly in the past couple of years.

Asset Quality Measures — The Great Balance Sheet Cleaning Exercise

Figures 3, 4, and 5 clearly capture the effect of the recent cleaning up of balance sheets. While the ‘sub-standard’ assets (assets which has remained as NPA for less than a year) and ‘doubtful’ assets (assets which have remained substandard for 12 months or more) have certainly reduced since 2018, the share of loss advances have been increasing, as it refers to the assets that have virtually been written-off as uncollectible. This is a consequence of the effort to clean the balance sheets of PSBs.

Net NPA’s (i.e. net of provisions) have also reduced since 2018 (Figure 6), while the quantum of write-offs saw a substantial increase during the same period (Figure 7).

Profitability — Still a Cause for Concern

Despite the progress made in terms of strengthening the balance sheets, the profitability of PSBs is still lacking, with the recent average return on equity and assets dipping into the negative (see Figures 8 and 9).

Relative Performance of PSBs between 2015–16 and 2020–21

In order to understand the relative performance of banks over the past five years, I use Principal Component Analysis (PCA) to construct indicies for asset quality and profitability. I use the simple difference between March 31 2021 and March 31 2016 of each of the variables mentioned in Table 5 as the data for the analysis. This would enable us to rank the 12 current PSBs based on their performance over the five years (of course, it is not path dependent). The results are presented in Figure 10.³⁰

Figures 11 and 12 look at the correlation of the constructed index with the change in government holding over the period (the change in government holdings is reported in the last column of Table 4). The results show a very clear negative correlation (i.e. worse the performance differential, greater increase in government holding over the period). It is correlational evidence, but is logical none the less and could potentially be causal.

The impact of the current EASE reforms will become more evident in the coming days. Irrespective, one can safely conclude that apart from a few banks such as the State Bank of India, Punjab National Bank, Bank of Baroda and Canara Bank, the asset quality and profitability of PSBs are still a cause for major concern, as things have not improved considerably yet.

Endnotes:

[1] Incidentally, this was the day prior to Apollo 11’s successful landing on the moon. It is indeed uncanny that India banked left just as the US arguably claimed victory in the space race.

[2] Shri. R.C. Cooper was a shareholder of the Central Bank of India and a prominent leader of the Swatantra Party (Kidwai, 2019).

[3] Primarily based on the ‘Objects and Reasons’ section of The Constitution (Twenty-Fifth Amendment) Act, 1971.

[4] GDP data is from World Bank (https://data.worldbank.org/indicator/NY.GDP.MKTP.CN?locations=IN).

[5] A few years later, ‘The Constitution (Forty-fourth Amendment) Bill, 1978’ omitted Article 31 and 19(1)(f). The right to property in India and the powers of the government are widely debated topics even today.

[6] Since the dissolution of the Swatantra party in 1974, there has not been a strong mainstream representation of the classical liberal economic worldview in India. Leaders of the Swatantra Party, including the likes of Shri. Chakravarti Rajagopalachari and Shri. Minocher Rustom (Minoo) Masani were very much for the protection of the citizens’ right to property and their right to practice their trade/profession through mutual agreements amongst themselves. The government, in their worldview, had to be limited to just protecting these rights of citizens. This is very much in line with the classical liberalism of the west, professed by the likes of John Locke and Jean-Baptiste Say. See Rajadhyaksha (2019) for more details. Also see the Shri. Masani’s famous speech against the nationalisation of banks during the eighth session of the Lok Sabha on July 25, 1969 (Lok Sabha Secretariat, 1969 — pp. 278 to 280).

[7] See Agrawal (2019) for understanding the banking sector during the late 1960’s and the motivations for this policy.

[8] This was part of a four-tier banking structure, where there were large international banks, pan-India banks, regional banks, and rural banks.

[9] See pages 127 to 132 of Narasimham et al (1991)

[10] Also see Sampath, 2021 for more details about the banking reforms (a podcast with Prof. Amol Agrawal of Ahmedabad University).

[11] Shri. M. Narasimham was the governor of the RBI in 1977.

[12] One of the other major recommendation in the broader banking perspective was the conversion of Development Finance Institutions (DFI) such as ICICI and IDBI into full-fledged banks.

[13] This refers to the recognition of advances as Non-Performing Assets (NPAs) if the interest payment/installment of principal is not made for more than 90 days since the due date. See master circular of the Reserve Bank of India — DCBR.BPD. (PCB) MC №12/09.14.000/2015–16. The circular also has the requirements for the other asset classification such as ‘substandard’, ‘doubtful’, and ‘loss’.

[14] For example, mergers such as that of Bank of Baroda, Dena Bank, and Vijaya Bank (Ojha, 2020).

[15] See Annex 2 of RBI circular DBOD.No.BP.BC.№37 /21.04.132/2008–09 dated August 27, 2008 for the complete definition of a restructured asset.

[16] See para 6.2.2 of RBI circular DBOD.No.BP.BC.№37 /21.04.132/2008–09 dated August 27, 2008.

[17] See DBOD.BP.№104/21.04.132/2008–09 dated January 2, 2009.

[18] Drawing power is calculated as the value of security pledged minus the margin requirement of the bank.

[19] Irregular portion refers to the difference between the outstanding loan amount at the time of restructuring and the amount of drawing power. The principal component of the irregular portion gets converted to WCTL, while the interest component is converted into a funded interest term loan (FITL). See Chapter 7 of Suresh and Paul (2014) for more about restructuring.

[20] The AQR was started in 2015–2016 under Shri. Raghuram G. Rajan’s governorship, see Ghosh, 2021 for more details. Chapter 7 of the Economic Survey of India 2020–2021 claims that the AQR failed in identifying all bad loans, leading to a significant underestimation in the capital required to be replenished. Further, the economic survey noted the AQR failed to capture the true extent of ‘evergreening’ exposure of banks. Evergreening refers to the practice of providing new loans on top of existing sub-standard or doubtful loans.

[21] Ministry of Finance, January 2018.

[22] The setting up of the autonomous ‘Banks Board Bureau’ was one such policy. The bureau is mandated to advice the central government with regards to the corporate governance of nationalized banks. Further the bureau would help banks develop business strategies and raise their own capital (See https://banksboardbureau.org.in/bureau-profile/).

[23] Comptroller and Auditor General of India, 2017

[24] Ministry of Finance, December 2018

[25] Ministry of Finance, February 2021 (2021–2022 Budget Speech)

[26] pp refers to percentage points.

[27] CLEAN — Clean credit, Leveraging data, Ensuring accountability, Action against defaulters, NPA recover

[28] SMART — Speedy, Multi-channel reach, Accessible and affordable, Responsive, Technologically enhanced

[29] The metrics were identified by the Indian Bankers Association and the Boston Consulting Group. See https://www.iba.org.in/circulars/ease-enhanced-access-and-service-excellence_600.html

[30] I run two separate PCAs for each of the two correlation matrices (namely, asset quality correlation matrix and profitability correlation matrix). The first principal component is used as the respective index. The approach is very similar that in my earlier article about asset quality and profitability of PSBs, published in February 2021 (https://akshaynatteri.medium.com/asset-quality-and-profitability-of-public-sector-banks-psbs-251c37bc0d07).

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Author: Akshay Natteri Mangadu