No more Rajagopals

R Gandhi, one of the deputy governors of the Reserve Bank of India (RBI), gave a very interesting speech titled Indian PSU Banking Industry: Road Ahead in Kolkata last week.
As a part of the speech he presented a table (a part of which is reproduced below) which shows how public sector banks (PSBs) are lagging behind their new generation private sector counterparts, on all parameters. 

 Public sector banks New generation private sector banks 
Return on Equity 16.5515.319.7115.3816.8117.06
Return on Assets
Net Profit Margin
Net Interest Margin 2.842.642.483.223.463.56
Staff Expenses / Total Income 10.7410.4810.998.978.397.96
Source: Reserve Bank of India

The new generation private sector banks generate better returns for their shareholders, operate at better margins and surprisingly even have a lower staff cost as a proportion of the total income they make, in comparison to public sector banks.
While one expects these banks to have done better than public sector banks, when it comes to returns to shareholders as well as operating margins, one did not expect them to have lower staff expenses as a proportion of their total income. That indeed is a major surprise.
There are multiple reasons for this difference in performance. First and foremost, private banks do not have to deal with political pressure to make loans to favoured individuals and companies.
Take the case of Lanco Infratech, a company, whose founding chairman Lagadapati Rajagopal was a member of the last Lok Sabha from the Congress party. This company, as on March 31, 2014, had total loans amounting to a whopping Rs 34,877 crore. Against this the company had an equity of only Rs 1,457 crore, meaning a debt equity ratio of 24:1.
To put in a simple way, the situation is similar to you and I approaching a bank for a home loan for a home priced at Rs 50 lakh. The bank agrees to give us a home loan of Rs 48 lakh and we need to put in only Rs 2 lakh from our end(which is essentially what equity is) to buy the home. This would mean a personal debt equity ratio of 24:1.
Of course, no bank would do this and would ask for a downpayment of at least 20% of the home price or Rs 10 lakh in this case. But public sector banks did not operate in a similar way when it came to giving out loans to crony capitalists. Crony capitalists got away without putting much of their own money at risk.
And the public sector banks are paying for the same now. The financial stability report released by the Reserve Bank of India (RBI) late last month put the stressed advances of public sector banks at 12.9% of their total loans. For private sector banks the same number was at 4.4%.
The financial stability report further points out that: “Among bank groups, exposure of public sector banks to infrastructure stood at 17.5 per cent of their gross advances as of September 2014. This was significantly higher than that of private sector banks (at 9.6 per cent) and foreign banks (at 12.1 per cent).” It is well known that many crony capitalists in India operate in the infrastructure sector. The higher exposure to this sector has led to higher stressed advances as well.
Interestingly, the government conveyed to the public sector banks at a recent retreat in Pune that it would not interfere in their commercial decisions.
“The banks/financial institutions should take all commercial decisions in the best interest of the organization without any fear or favour,” the government said.
If the government sticks to this decision the performance of public sector banks is bound to improve in the days to come. India does not need any more Lanco Infratechs and its Rajagopals. As RBI governor Raghuram Rajan put it in a recent speech, India is “a country where we have many sick companies but no “sick” promoters.” If public sector banks need to do well this needs to be corrected in order to ensure that big business does not take them for a ride in the years to come.
It needs to be pointed out here that employees of public sector banks are selected through highly competitive exams and they are not any lesser than their private sector counterparts. Hence, they have the ability required to figure out which loans to give and which to avoid, if they are allowed to operate on their own without any political interference.
Nevertheless, public sector banks need to put a proper performance appraisal system in place, something that their private sector counterparts already have. As RBI deputy governor Gandhi said in his speech: “The Performance Appraisal System (PAS) needs a complete revamp. Currently the PAS makes no meaningful distinction between individuals for identifying or deploying talent, skills and / or specialisation; nor does it guide determining compensation.”
In fact, stock options play a very important role in retaining and motivating managerial talent to perform better at new generation private sector banks. The government needs to seriously take a look at introducing stock option plans linked to performance, in public sector banks as well.
Further, the government currently owns 25 public sector banks (which includes the State Bank of India and its five associates). There is no reason as to why the government should own 25 banks. It is time that the government got around to selling at least 15 of the smallest banks. That would leave five big banks and SBI and its associates.
The money thus generated could be used to fund a part of the public infrastructure that India badly requires. This topic is a political hot potato and sooner the government starts work on it, the better it is going to be for it.
This will also save the government from another major headache. The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.”
This is not exactly a small amount and by selling 15 banks this won’t totally be government’s headache any more. Further, by concentrating on the largest banks, the government can ensure that these banks are better capitalized in the days to come and can strongly work towards government’s projects like financial inclusion.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article originally appeared in the Daily News and Analysis on Jan 20, 2015