The day India's banks died because of political priorities of a populist PM

Fifty years ago, India took a wrong turn leftward from which it is yet to recover: On July 19, 1969, the government took over the banking system, nationalizing 14 banks which together controlled 85% of bank deposits. Today, even after a quarter century of liberalization, state-controlled banks still control 70% of the sector’s assets. As a consequence, credit is weak, the private sector is stunted and India has to endure periodic banking crises and bailouts at taxpayer expense.

The legend around bank nationalization is this: Indira Gandhi, India’s prime minister at the time, felt that banks served the interests of crony capitalists and sought to find a way to extend credit to India’s farmers. The only way to force banks to open branches catering to India’s vast rural population was to take them over, she thought -- and so she did.

This is, of course, not what happened. In fact, bank nationalization was a by-product of a power struggle between Gandhi and rivals within the Indian National Congress party that was only superficially about economics. The quasi-socialist economy India’s founding generation had built worked fairly well for the first 15 years after independence in 1947, delivering growth and raising living standards. Amid war and famine in the 1960s, however, the model seemed to have failed -- and Congress dissidents sought to dismantle it.

Gandhi's brilliance as a politician lay in her ability to transform the most sordid political intrigue into high ideological disputation. She wanted to isolate her rivals, including her finance minister, and force them out of the government. So, she maneuvered them into declaring that the public sector was inefficient and should be dismantled. Then she herself took the opposite position, nationalizing the banks and leaving her enemies with no option but to go. It was a matter of intra-party politics, not poverty relief.

Some still claim that nationalization achieved its stated ends. The number of branches in rural India expanded as banks were ordered to open four branches in India’s villages for every one in its towns and cities. Agricultural lending increased, as banks were told that 18% of credit should go to farming and allied activities.

But the real effects of this increased credit were minimal. The Harvard Business School economist Shawn Cole found that “while nationalization initially spurred financial development and caused unprecedented amounts of credit to flow to agriculture, this came at a cost of lower quality intermediation. Moreover, a more than doubling of agricultural credit to villages led to no measurable increase in agricultural investment. Even the increase in credit was not sustained.”

The effect on industry, meanwhile, was clearly negative. Banks, once nationalized, became risk-averse and hidebound, rarely lending to new firms. Under-lending became chronic; manufacturers found themselves severely short of credit. Bank officials did not have to care about finding and evaluating profitable firms. Instead they lent to those companies selected, for whatever reason, by their political bosses.

Such cronyism led to periodic bad loan crises that required bailouts by the banks’ owners, the taxpayers. The same dynamic continues to this day: The last Indian budget set aside 700 billion rupees ($10.2 billion) for recapitalizing public sector banks. This means a total of 2.7 trillion rupees has been infused into the state-controlled banking sector since 2017. Even so, banks are still burdened with bad assets and reluctant to lend.

Many of us hoped that, with the growth of new and efficient private-sector banks, the old nationalized banks would slowly be squeezed out, starved of capital till they withered away. But Prime Minister Narendra Modi -- often compared to Indira Gandhi -- seems determined not to let that happen.

State banks are once again central to a prime minister’s anti-poverty rhetoric. Under Modi, public-sector banks are being forced to expand lending to the smallest entrepreneurs, with minimal security. Ratings agencies estimate that between 10% and 15% of these loans may already have turned bad in just a few years.

The government boasts of its vast expansion of no-frills bank accounts that it intends to use to overhaul welfare payments, while government-mandated insurance schemes have been introduced that bank officials say will cost them much more than they will bring in. Meanwhile, lending by public-sector banks to industry has slowed; private-sector banks have had to do most of the heavy lifting on credit growth.

Too little has changed in 50 years. A banking sector that should be stimulating growth and investment remains inefficient and wasteful, and the cause is the same: the political priorities of a populist prime minister.