There are few things more infuriating than public bailouts of private banks. That’s why, when banks get into trouble, many people would rather nationalize them entirely than rescue them. (In fact, after the 2008 crash, the U.S. reportedly came close to doing so.) But surprisingly, in India and China – two countries whose financial systems have long been dominated by public banks – the governments are responding to their current banking crises by moving toward more private control.

Consider what’s happening in India. Public banks there control about 75% of loan market share – but they’re struggling with grave and mounting challenges:

  • Public banks accounted for over 90% of the banking sector’s non-performing assets in 2014.
  • In the first quarter of this year, just four of India’s 39 listed banks reported net losses – but three of these are public sector banks.
  • In that same period, at least nine other public banks reported a drop in net profit compared with the first quarter of 2014 – with three of them reporting profit drops of over 70%.

Some of these struggles are driven by events that have also weakened private banks, like the fact that major corporations and the government took out large infrastructure loans during India’s recent boom years, for projects that have remained uncompleted as the economy has slowed. But on top of that, India’s public banks are dealing with structural challenges that the private sector doesn’t face – and these problems go beyond a few bad loans, or a temporary lack of capital.

Public banks in India have historically benefited from government protection from competition, in the form of special access to favorable policies for credit and liquidity adjustment, this protection comes with a price. They’re required to support the government’s economic goals, and to submit to a greater degree of outside control. As a result, they’re often forced to make banking decisions based on government mandates rather than business factors.

For instance, their high number of bad loans is due in part to banking policies that have allowed the government and its affiliated companies to borrow cheaply and accumulate significant debt. Political pressure to lend to certain sectors has also forced public banks to accept riskier loans, while limiting their ability to diversify their portfolios as much as private sector banks. Meanwhile, their leadership often feels constrained in responding decisively to challenges, fearing the possible consequences of constant government scrutiny of their decisions. These factors have not only left public banks more exposed to bad debt than their private sector counterparts, they’ve also hamstrung their efforts to address the problem.

In an environment where they must compete with each other – and with private banks – India’s public banks are fighting a losing battle on unfavorable turf. They’re also acting as a drag on the overall economy, as bad loans have crimped profits and reduced lending – a problem that clearly concerns the government. The Reserve Bank of India has encouraged banks to write off bad loans before they spiral into larger problems, and has even given them the power to convert unpaid loans into a majority equity stake in defaulting companies.

But the government hasn’t shown much willingness to simply recapitalize public banks en masse – a proposition that would require an estimated $75 billion over the next four years. Instead, it has emphasized that government capital will be available only to efficient and better-managed public sector banks. More importantly, it’s also fostering more private sector competition for these banks – it recently began issuing new banking licenses for the first time in a decade. And its finance ministry is allocating about 41% less capital for public sector banks for 2016 than it did for the current year. These maneuvers are likely to accelerate the growth in private banks’ market share, which seems to be exactly what the government wants: to let market forces clean up India’s public banking problems by gradually pushing the sector’s ineffective banks out of business.

In an even more striking development, China – the global flagship for government-controlled economies – seems to be pushing its financial system even more decisively toward the free market.

Like India, the Chinese government has used state-owned commercial banks for decades to prioritize the development of certain industries. It has also depended on them to support state-run companies, and to finance local government projects. Since this sometimes requires these banks to lend to companies, industries or projects with uncertain prospects, the government has traditionally supported them when these loans have gone sour. For instance, it has set up asset management companies (known as “bad banks”) to buy non-performing loans at a discount, then work them out for a profit. And along with propping up larger public banks, it has intervened to protect depositors when smaller banks fail. This has caused a public perception that deposits – and even wealth products – in all Chinese banks are backed by the government.

Predictably, these measures have distorted the market. Beijing’s efforts to provide cheap capital to state-owned enterprises has given these companies an advantage over private and foreign-run firms. But it has also necessitated government caps on the interest rates public banks pay, with these rates sometimes struggling to keep pace with inflation. And due to both government mandates and the perception of guaranteed payment on loans to state-owned businesses, Chinese banks give these enterprises the bulk of their cheap credit, leading to a shortage of affordable financing for the private small and midsize companies that contribute most to job growth. Both of these factors have spurred the growth of China’s “shadow banking” sector, in which informal lenders like trust companies and leasing firms offer wealth products and loans outside the regulated banking system.

So now the Chinese government finds itself in a quandary. With its economy slowing and its banks dealing with a growing bad loan problem, some analysts are worried that similar problems among shadow banking lenders – which borrow money from regulated banks – could spark a broader financial crisis. Yet government efforts to curb shadow banking could worsen the economic slowdown, as reduced lending spurs a drop in spending. And though Beijing has told banks to increase their formal lending to small businesses – and even to keep lending to insolvent local governments – these measures are likely to worsen their bad asset problem.

Things would be much simpler if the free market had been allowed to inform lending practices in the first place – and the Chinese government seems to realize this. In the past few months, it has made a series of moves to introduce market forces into the system:

  • In April, it introduced deposit insurance into the banking system, hoping to shake the public’s confidence that the government will bail out any troubled bank.
  • Around the same time, it allowed a state-owned company to default on a bond payment – for the first time in history – casting doubt on the implicit belief in these businesses’ government backing.
  • Government officials have suggested that it will soon remove the ceiling on bank deposit interest rates, allowing the market to determine the cost of credit.
  • It recently announced plans to open the door to more private banks and foreign investment to shore up the banking sector.

These measures are likely to force public banks to recalibrate their approach, basing lending decisions on borrowers’ creditworthiness, rather than their state-owned status, and attracting customer deposits through competitive interest rates.

Whether these efforts – or similar ones in India – will be enough to solve the countries’ financial challenges remains to be seen. But the struggles of their public banking systems – and their embrace of the free market as a solution – might give pause to those in other countries who are drawn to a government-run approach.

 

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