Public or private? The future of banking in India and the United States
One cannot help but be struck by the apparent irony of recent trends in the banking system in India and the United States. Stimulated by a lack of financial inclusion, a public banking movement is rapidly gaining ground in the United States, a stronghold of free markets. In contrast, India, a prime example of state intervention and domination of state-owned banks, seems to be heating up quickly at the idea of bank privatization.
The debate over the benefits and costs of public versus private banks is not new. Dating back to Alexander Gerschenkron in 1962, the development perspective views the government’s presence in the banking sector as a way to overcome market failures in the early stages of economic development. The central idea is that public banks can improve welfare by allocating scarce capital for socially productive uses. In contrast, the political point of view argues that vested interests can requisition the lending apparatus to achieve political goals. The capture of political or special interests can distort the allocation of credit and reduce the efficiency of allocation in state-owned banking systems.
Convinced by the evidence that government ownership in the banking sector leads to declining levels of financial development and growth, waves of banking sector privatizations swept through emerging markets in the 1990s. privatization of banks as an effective means of achieving economic and financial development. Indeed, international data suggests that bank privatizations have improved both the efficiency and profitability of banks, in particular, by increasing solvency and liquidity while reducing distressed or underperforming assets. India is therefore a little late.
Public sector banks (PSBs) dominate India’s banking sector, controlling over 60 percent of banking assets. The private credit-to-GDP ratio, a key measure of credit flows, stands at 50%, well below international benchmarks – in the US it is 190%, in the UK 130%, in China of 150 and South Korea. it’s 150%. Credit quality is also problematic. India’s gross NPA ratio was 8.2% in March 2020, with striking differences between PSBs (10.3%) and private banks (5.5%). The end result is a profitability of PSBs much lower than that of private banks. Obviously, the rationale for privatization flows from these considerations.
While the United States epitomizes the private banking model, a nationwide public banking movement is in vogue – this includes recently introduced government bills from California to New York. If modeled after the Bank of North Dakota, the only public bank in the United States, reports suggest that public banks can contribute to state revenues, support community banks, finance infrastructure projects. government and help small businesses grow by offering lower interest rates and fees. .
The public banking movement can also contribute to effective government transfers and financial inclusion through universal checking accounts. According to pre-pandemic data from the Federal Deposit Insurance Corporation (FDIC), 5.4% of households in the United States are unbanked. India is no stranger to the imperative of digital financial inclusion. The Jana Dhan Yojna (PMJDY) is a flagship program designed to overcome slippages in the delivery of transfer payments to final beneficiaries. The program is administered primarily by state-owned banks.
The resounding success of Indian PSBs in implementing the PMJDY while missing the target in creating high quality credit highlights a critical gap between a bank’s assets and liabilities. Banks perform two functions at a fundamental level: making payments and collecting deposits on the liabilities side and creating credit on the assets side. The function of payment services, a hallmark of financial inclusion, is similar to a utility company – banks can provide this service, a public good, at low cost in a universal manner. On the loan side, on the other hand, it is an optimal allocation of resources through better credit assessment and better monitoring of borrowers. Private banks are more likely to have the right set of incentives and expertise to do this. It is not surprising that PSBs in India are better suited to fulfill public good functions, while private banks appear to be better suited to allocating credit.
The optimal mix of public and private banking comes down to what you need from your banking system and the particular frictions your economy faces. When the gap between social and private benefits is large, as in the case of financial inclusion, public banks have a strong case. At this point, inefficiency in the allocation of capital seems to be a bigger problem for the Indian banking sector, while in the United States the debate centers on the public goods aspects of the bank. Therefore, it may be wise for the United States to give serious thought to public banks that can be used for financial inclusion, in line with the success of PMJDY in India. On the other hand, the selective privatization of inefficient PSBs is a welcome move for the Indian banking sector.
This article first appeared in the print edition on March 9, 2021 under the title “Getting the bank balance right”. Chari is professor of economics and finance and director of the Modern Indian Studies Initiative, University of North Carolina at Chapel Hill and Purnanandam is Michael Stark professor of finance at Ross School of Business, University of Michigan