Clipped from: https://economictimes.indiatimes.com/industry/banking/finance/banking/view-policies-that-increase-competition-between-banks-can-improve-the-lending-standards-of-psbs/articleshow/81955959.cms
Synopsis–IF PSBs can reduce bad loans, and offer better deals to their good clients out of fear of losing them to the private banks, this will ultimately help the overall economy.
From the bank nationalisation movement in 1970s to the privatisation of two public sector banks (PSBs) proposed by GoI recently, India has completed a full circle. Higher gross non-performing asset ratios (10.25% for PSBs vs 5.45% for private banks in 2020) and the constant need for recapitalisation of PSBs (around ₹3 lakh crore since 2015) may explain GoI’s decision for privatisation. GoI will still have a tremendous presence in the banking sector through other PSBs.
The national development finance institution (DFI) to be set up with the equity capital of ₹20,000 crore, with plans to fund projects worth ₹3 lakh crore over the next few years, suggests an expanded footprint. So, the question is not whether GoI will hold a stake in banks but, rather, given that it does, can one improve the lending discipline of PSBs, and if so, how.
In a March 2021 paper, competition from the private sector is found to play a reassuring role in disciplining lending by PSBs. In 2011-12, RBI relaxed branching restrictions, allowing banks to freely set up branches across the country. However, banks were mandated to open a branch in a smaller city or town for every branch it opens in a bigger city.
First, the paper shows that this led to substantial branch expansions in Tier 3 cities across India, and in that sense, the regulation succeeded. More importantly, though, it increased private competition faced by PSBs operating in these smaller towns, as private banks had to open branches in these smaller towns to be able to open branches in bigger towns.
A striking result regarding PSB lending disciplining was found. In these Tier 3 towns that benefited from the regulation, PSBs were 6-7% more likely to reduce lending to unprofitable firms. These are the loans that ultimately end up as non-performing assets (NPAs). In other words, competition did discipline PSBs.
Good lending practices are just an intermediate step in creating more productive firms that hire more workers. Was there any evidence of this effect? Relative to non-Tier 3 towns, efficient plants located in Tier 3 towns saw about 10% increase in employment in only a few years after the 2011 branching. There was no trend of increasing employment in these towns prior to 2011. In fact, employment was dropping a bit relative to non-Tier 3 towns a couple of years prior to the RBI rule change.
Similar results are found for plant sales, assets, productivity parameters, etc. Further, companies that formed credit relationships with private bank entrants in districts exposed to branching are, subsequently, more profitable. In all, strong support for the argument that private competition helped reduce the inefficiencies of government-owned banks — and helped more productive plants grow faster — was found.
This does not mean that PSBs are inherently inefficient, and are not trying to screen most loans. In fact, a March 2019 paper points out that PSBs also utilise available relevant credit bureau information regarding their new borrowers, just like private banks. However, PSBs do not do so for legacy borrowers. The study finds that universal adoption of the standards can help reduce loan delinquencies.
The March 2021 paper suggests that more competition can provide the needed incentives for PSBs to further tighten their lending standards. If PSBs can reduce bad loans, and offer better deals to their good clients out of fear of losing them to the private banks, this will ultimately help the overall economy.
So, what does this all mean for privatisation reforms? Of course, the devil is always in the details. However, without competition, government ownership of banks is extremely costly. This discussion is also relevant for the new DFI set-up. One hopes that there too, private banks are encouraged to lend alongside the DFI.
In general, policies that increase competition between banks in India can improve the lending standards of PSBs. The resulting improvement in efficiency of the banking system overall increases GDP and provides jobs.
(Javadekar is assistant professor, Indian School of Business (ISB), Hyderabad, Chakraborty is associate professor, University of Miami, US, and Ramcharan is professor, University of Southern California, US)