Viral Acharya - Part One

The 2008 financial crisis was supposed to engender soul-searching and a critical reassessment on the part of mainstream economists. But this mostly hasn't happened. It definitely hasn't happened to Viral Acharya, the newest Deputy Governor at the Reserve Bank of India. What Acharya seems to have taken away from 2008 and its discontents is that public-sector banks are getting an easy ride. At that time, India's relative stability was predominantly attributed to its publicly-controlled banking system. Our PSBs had not indulged in the risky behaviour that marked America's big bad banks, or so it went.

But Acharya disagrees.

While Indian financial firms have been fairly resilient compared with their global counterparts, Indian private sector firms faced greater losses compared with public sector firms during 2008–09. This was in spite of private sector firms having lower exposure to the crisis based on precrisis market indicators. By relocating their deposits, investors seemed to reward public sector firms while penalising private sector firms with similar risk. This should not be interpreted as greater resilience of state-owned banks vis-a`-vis the private financial sector. It was access to implicit and explicit government backing rather than ownership by the state that helped public sector banks perform better. Interpreting this
lack of a level-playing field as the relative stability and efficiency of public sector banks relative to private sector banks appears questionable.

Acharya feels that the only reason the PSBs performed better than the private banks was because citizens knew that the government guaranteed their deposits while no such guarantee existed for deposits with private banks. So depositors moved their money to PSBs knowing that they would be bailed out in the event of a system-wide failure. Therefore, in the event of a crisis, PSBs would always outperform private banks even if they were technically more vulnerable to the crisis. Acharya proceeds to test this out (using a methodology that I am not in a position to criticize) and concludes in the affirmative, PSBs were not more stable, they were just perceived to be safer.

He concludes with a familiar (and seemingly inevitable) refrain - privatization:

While there is always a justification for greater presence of government institutions in the financial sector (or greater extent of government intervention in a crisis), this is likely associated with the misfortune of crowding out the private sector in the long run unless the government intervention has a graceful exit attached to its tail... Government bailouts – and investor and depositor anticipation of such bailouts – for public sector banks have deep consequences on competitive forces in the financial sector, potentially shaping their long-run form and always stacking the odds against the flourishing of private banks.

Sigh.