An open letter to the finance minister

Dear Mr Jaitley,
Even though the government overshot its fiscal deficit target—4.1% of gross domestic product—for the year in the first nine months of 2014-15, we are fairly confident that you will succeed in sticking to it by paring expenditure in the January-March fourth quarter, taking care of lower revenue collection. We are also certain that you will reiterate your commitment to fiscal consolidation when you present the Union budget over the weekend.
The purpose of writing this letter is not to outline an agenda for stimulating public investment, bringing down fiscal deficit, and launching big and bold reforms but to flag an issue which is very critical for the nation’s economic growth—reforms in public sector banks (PSBs), which account for 70% of the banking industry. You didn’t have your team in place when you presented the last budget in July. This time around, I presume, you are ready with a new team and new thinking.
The PSBs are capital-starved. On top of that, they have been piling up bad assets (the two issues are related as banks need to set aside money to provide for bad assets and that, in turn, erodes their ability to build capital), and governance is also an issue. You would need to address all three of them on a war footing.
Early this month, the government announced that it would infuse Rs.6,990 crore capital into nine PSBs. You have changed the criterion for capital allocation, using bank’s profitability parameters such as return on assets and return on equity. From your approach, it is clear that, henceforth, only efficient public sector banks will be rewarded with capital while others will have to fend for themselves. How will the relatively weaker public sector banks generate capital? In your July budget speech, you had said that the government would need to infuse Rs.2.4 trillion in public sector banks by 2018 to enable them to meet the Basel-III international norms. You seem to be very conservative as, according to a Reserve Bank of India (RBI) estimate, PSBs will need around Rs.8 trillion of capital till March 2019 if their annual credit growth is 20%, and the need for capital will be around Rs.5 trillion if the credit growth is around 15%.
For the record, the government has infused capital of Rs.14,000 crore in 2014, Rs.12,517 crore in 2013 and Rs.12,000 crore in 2012. Clearly, it is not in a position to pump in the required capital. What will the banks do then? How will they support the credit needs of companies and individuals when the Indian economy picks up growth momentum? In your last budget, you had said that while preserving public ownership, the capital of these banks would be raised by increasing the public shareholding in a phased manner via sale of shares to Indian citizens. It will be impossible to meet the capital requirement this way. Investors are not excited about buying equity of PSBs as, based on price-to-book ratio, a popular valuation metric for banks, almost all of them are undervalued.
One solution could be formation of a bank holding company, as suggested by an RBI panel. This will free bank employees from the shackles of investigative agencies such as the Central Bureau of Investigation and the Central Vigilance Commission, and speed up the decision-making process on the one hand and, on the other, prop up their valuation. The other option could be selling the government stake in the less efficient PSBs and using the money to recapitalize the efficient ones. You do not need to hold a majority stake in all PSBs—retain it in a few relatively big and well-managed banks and bring down stake in others to 26%. This way, you can privatize them and yet continue to hold the power to block any special resolution. The capital raising efforts by public sector banks, other than the capital infusion by the government, face challenges because of their relatively low equity valuations compared with their private sector peers. The valuation will rise with improvements in asset quality, governance structures and operational efficiency.
The stressed advances of the banking system are at least 12% now and the bulk of them belongs to PSBs. In September, 12.9% of assets of PSBs were stressed assets compared with private banks’ share of 4.4%. Since then, they have risen further. One reason behind this is PSBs’ high exposure to the infrastructure sector; often they were tacitly pushed by the government to do so. Around Rs.10 trillion worth of infrastructure projects have not been able to take off in the absence of various clearances.
At the two-day Gyan Sangam retreat in Pune in January, both Prime Minister Narendra Modi and you committed a hands-off policy and full autonomy for PSBs. I would love to hear you reiterating this in the budget. For quite some time, RBI has been interacting with the finance ministry to change the structure of bank boards and reform the human resources policy by giving a longer tenure to their chairmen and allowing PSBs to offer market-related salaries to their employees, among other things. You would need to focus on governance in PSBs and strengthening their boards. You have taken the first step by changing the appointment procedures of the chiefs of PSBs and splitting the post of chairman and managing director at relatively bigger banks into two, but no chairman has been appointed as yet. I hope professionals with the right credentials will be chosen for the job. Also, you’d need to restructure the boards of these banks. Once these banks become better governed and competitive, their market value will go up. This will free the government from the burden of pumping capital into these banks every year.
Wishing you all the very best,
Yours sincerely,
Tamal Bandyopadhyay