A Plan to Corporatize PSU Banks

by Raghuram Rajan and Ajay Shah

Despite the recent upswing in their profitability, PSU banks are in a bad way. PSU banks do have strengths: a core of excellent staff recruited in the days when jobs in PSU banks were indeed prestigious, a loyal set of depositors who see a deposit in a PSU bank as the only safe instrument in a market replete with scams, and branches in prime locations around the country. However, these assets are rapidly depreciating.

At the simplest, technology is rapidly eroding the importance of the branch network. ATMs and the Internet are making it possible for competing banks to obtain a large deposit base without incurring the costs of the PSU-style branch network.

PSU banks are profitable today, not because they are making good investment decisions but because they have an explicit guarantee from the government, which allows them to offer a safe haven to investors. In other words, they enjoy a hidden subsidy from public money. When depositors learn about money market mutual funds, money will flow out of bank deposits, which will hurt PSU banks.

More fundamentally, the skills required of bankers have been profoundly altered. It is just not enough for senior bankers to be able to hobnob with important clients, they also have to be intimately familiar with concepts like option deltas, inverse floaters, and Value at Risk. This will require new recruitment, but current pay scales at PSU banks will not attract anyone remotely competent in these matters.

In order to do credit, banks require new competence (e.g., engineering feasibility studies and worldwide market potential), and the willingness to exercise business judgment and go beyond fixed rules (e.g., loans cannot amount to more than 80% of current assets). In an atmosphere where many loan defaults lead to criminal investigations, where the only safe path is to follow all the rules laid down by ancient committees, bankers will simply not do credit.

What is a way forward for the PSU Banks? We believe that privatization is not a solution; that strategic sales of PSU banks are not a solution:

Privatizing by selling in the open market is not an answer either because without large investors exercising governance, bank management can become a law unto their own, feathering their own nests, rather than serving the public or shareholders. The sequencing must be such that governance structures fall into place before privatization.

The first step in this path -- which is compatible with political constraints and with economic policy -- is hence to corporatise PSU banks. Essentially, this means distancing PSU banks from the constraints of government pay scales and government incentive systems (i.e., get the CVC and CBI off the backs of bankers) and, equally important, distancing them from government interference in lending and promotion decisions, while building new governance structures.

The distancing from government constraints is relatively easy - it requires changing a number of statutes that currently constrain public sector banks. Distancing from government interference is much more difficult. We have seen that the government has sought to impose its will even on companies it has a minority stake in. What ensures that it will refrain from interfering in PSU banks? How does one create an atmosphere where banks are run in the public interest rather than in the interests of bureaucrats, industrialists, and politicians?

We propose the following scheme. Create a number of holding funds (say 10) and appoint fund managers for them. These fund managers should be individuals or firms with expertise in running funds and a lack of conflicts of interest. The government will place its holdings in public sector banks in these holding funds. Initially, it will allocate its stake equally. So if the government's stake in Bank of India is 62% of total shares (with the rest held by the public), each fund will start out with 6.2% of BOI shares.

The fund managers have two main roles. The first is to manage the portfolio to maximize returns. They would do this by trading bank shares with each other. This trading will be distinct from trading in the stock market (where 38% of the bank's shares trade), but presumably, information will flow between markets. From the government's perspective, this is a zero sum game because what one fund makes, the other fund loses, and the government owns them all.

The virtue of allowing the funds to alter holdings is that it permits the second role: That of governance of banks and performance measurement of funds. It allows funds to obtain controlling stakes and impose some measure of governance on banks in their portfolio by electing appropriate directors and pressuring under-performing management. Simultaneously, funds can generate higher returns, both by trading astutely, identifying underperforming or undervalued banks, and by governing them well.

There are virtues of dividing up bank stakes among the funds (so no fund should be able to own more than, say, 20% of a bank's shares) and creating competition between them. Phone calls which seek to bring pressures on a fund will be less effective when voting is secret and no single fund has a controlling stake. Moreover, funds will be less willing to oblige when they know that bad decisions will affect the value of their stake, and reduce their fund's relative performance. This will make them look bad relative to other funds.

Finally, not only is fund performance a source of incentive (fund managers will be paid a significant bonus based on their fund's performance), it is also a source of security: Presumably, those who ignore political pressures the most will perform best. It will be hard for the government to fire a fund manager who is performing well.

This path offers the hope of distancing banks from government constraints and improving their performance. It maintains the public sector character of banks while giving them the incentive to work in the public interest. In the long run, if governance improves and the national consensus in favor of making these organizations widely held private institutions increases, the shares held by the holding funds can be traded with private sector funds, thus effectively privatizing these banks. In the short run, its greatest virtue is that it will cost little, and will, almost certainly, improve matters.

Raghuram Rajan is Gidwitz Professor of Finance at the University of Chicago and Professor at the ISB. Ajay Shah is Consultant at the Ministry of Finance and Associate Professor at IGIDR. The views are those of the authors only, and not of their respective employers.

Back up to Ajay Shah writing for the mass media (2002)