Context:

• The troubles of the banking sector, and public sector banks (PSBs) in particular, are well known. Reform proposals have focused largely on ownership and have issued strident calls for privatization. Even if there was political support for this idea, there are a few important challenges.

Confidence of Customers

• The total current account and savings account (CASA) base of PSBs in India was Rs30.2 trillion (including State Bank of India, or SBI) and Rs 18.9 trillion (excluding SBI) in 2017. By and large, this reflects the confidence of customers in the implicit government support to these entities.
• One has to only recall the brouhaha on the Financial Resolution and Deposit Insurance (FRDI) Bill’s bail-in issue to realize that banking customers in India expect their deposits to not face any uncertainty, even when the bank is failing.
• In such an environment, and where alternatives in the form of other well-managed banks with significant branch networks are not yet fully in place, privatization could cause a flight of savings from banking to physical assets—a trend that has been in any case stubbornly persistent despite all the gains in financial inclusion. 
• The core strength of PSBs is the deposit franchise.
• Their branch network in far-flung areas,combined with the trust reposed in the government, means that they are the preferred choice of the mass-market customer, rural customers, and, often, retired individuals.

The Issue:

1. Given the low deposit rates offered by banks in India relative to the risk-free rate, these deposits represent tremendous value in terms of a profitability cushion.
2. The erosion of value really happens on the lending side.

This occurs due to a few reasons:

1. firstly, mandated lending through various schemes, in addition to priority sector lending targets;
2. secondly, the poor risk management competencies of banks, particularly vis-à-vis managing the concentration risks of specific sectors and business groups; and
3. third, lack of specialized underwriting skills, given that customers tend to range from large firms and farmers to small businesses and mortgages.

• The math here is straightforward—the risk-adjusted return from the lending activity of the bank erodes all the value created by the deposit-taking activity.

The suggested model

• On the lending side, rather than PSBs directly originating credits through branches and hoping for the best,
• they would assemble a portfolio of credits that are originated by specialist institutions (non-bank finance companies and small finance banks)
• Assembling this portfolio of loans can be done through a variety of ways,
  such as direct purchases of their loans, and by investing in securitized assets representing underlying loans originated by these specialist institutions
• This also implies a clearer role for these specialist institutions and their contributions to extending credit in an efficient manner

This is not a new idea

• Glimpses of this model can be seen in the priority sector lending certificates market and the micro-loan securitization market where specialists trade assets with non-specialists in a markets framework
• The idea will increase the ratings of the book asset of the PSBs
• The implementation of this idea would ensure a more efficient approach to capital, while, importantly, preserving the deposit franchise of PSBs
• This is because under this model, the PSB asset book would be highly rated owing to the high levels of diversification and granularity in underlying loans

The way forward

• Portfolio-level guidelines would need to be specified,
• The model would be subjected to high-quality risk reporting requirements that would be made possible by the availability of accurate and complete data (along business lines, legal entity type, asset type, industry, region and other groupings) that permit identifying and reporting risk exposures, concentrations and emerging risks

Source:Livemint