Viral V. Acharya NYU Stern, CEPR and NBER (based on “State Ownership and Systemic Risk: Evidence from the Indian Financial Sector during ”, with Nirupama Kulkarni, Hass School of Business, UC Berkeley, and Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance, with Stijn van Nieuwerburgh, Matthew Richardson and Larry White, Harper Collins (India)) July 2011 Is State Ownership in the Indian Banking Sector Desirable?

India: Crisis of 2008 Triggered by global financial crisis of August 2007 NIFTY fell nearly 60% from its peak in January Strong performance of Indian financial firms.  Capitalization: High CRAR of 13% (globally 8.2% to 17.7%).  Quality of assets: NPL ratio decreased to 2.3%  Profitability: Higher ROA of 1% as of March, Attributed to high regulation preventing excessive risk taking. Attributed also to the presence of state-owned banks.

Crisis of 2008

Public and Private Sector Performance

Policy (Political!) Implications The ruling party leader, claimed that “public sector financial institutions have given our economy the stability and resilience we are now witnessing in the face of the economic slowdown.” Finance minister echoed these sentiments by claiming India’s PSBs were strong pillars in the world’s banking industry. Source: Frontline, 2008 The emerging pre-crisis consensus for privatization of the financial sector appears – at least for now – to have turned on its head…

An Inquiry and Concern Inquiry: Did government ownership help PSBs outperform the private-sector counterparts or was it government guarantees? (Indian Bank Nationalization Act: Explicit guarantee for PSBs) We compare public and private sector performance during the crisis period of Jan 2007-Feb 09. We relate systemic risk exposure of financial firms to crisis based on  Realized returns; Deposit Growth; GOI capital injections Concern: The PSBs through crisis-time guarantees may have captured significant market-share and crowded out private sector How will the private sector respond? Will there be a risk of a “race to the bottom” in risk-taking?

Data Relate pre-crisis systemic risk to crisis performance: Realized Returns (stock return data):  70 financial institutions: Public (19 firms), Private (51 firms) Deposit growth (annual RBI data):  39 banks: PSBs (17), Private sector banks (22) Impact of GOI guarantees (World Bank report + returns)

Key Results I. Ex ante systemic risk (exposure to market-wide crash) and ex post performance for the two sectors are strikingly different. Public sector firms had greater ex ante systemic risk and yet outperformed private sector firms. II. There was a flight of deposits from private firms to PSBs Surprisingly, public sector firms with greater systemic risk performed better. III. PSBs with greater systemic risk received greater GOI support.

I. Systemic Risk measure: MES Marginal Expected Shortfall (MES) measure  Captures tail dependence of stock return on the market as a whole.  Negative of the average returns for a given bank in the 5% worst days for the market returns (S&P CNX NIFTY index) during the pre-crisis period from Jan-Dec  Contribution of each firm to systemic risk in the event of a crisis.  Found in a series of research papers at NYU-Stern to help explain performance in a crisis of banks across the world (but as in the Indian study, less so for state-owned banks) Overall average MES of 3.79% for all firms in our analysis.  PSB : 4.34%  Private sector banks : 3.58%.

Realized Returns: Private Sector Firms

Realized Returns: Public Sector Firms

A Case in Point

Robustness Checks Same banks were systemically important in 2006 and  MES Ranking for 2006 strongly related to 2007 (R 2 of 17.6%).  $MES Rankings even more stable(R 2 of 92.5%). Similar results obtained with BSE SENSEX. Results are robust to controlling for Greater past performance Leverage Size Global beta (as the Indian crisis was partly due global problems) Placebo tests outside of the crisis  2004, 2005, 2006 and 2007 do not show similar trends.  Confirms the intuition that government guarantees are more important during crises.

II. Deposit Growth Helps understand the relationship between realized returns and systemic risk. Depositors shifted capital out of private banks to PSBs. New results also suggest maturity-shortening for private banks. “Flight-to-Safety”: Following Lehman, Infosys transferred Rs. 10 billion in deposits from ICICI to SBI in Q *. * Economic Times (2009). BUT: Depositors shifted capital out of high-MES private banks to high-MES PSBs!

Public vs Private Sector Performance: Deposit Growth

Deposit Growth: Private Sector Firms

Deposit Growth: Public Sector Firms

III. Capital Injection in PSBs GOI announced fiscal stimulus in December Promised capital to PSBs to help maintain CRAR of 12%.  Dec. 2008: GOI requested Rs.1700 cr. from World Bank  Dec.2008-Feb. 2009, announced capital injection in 4 PSBs: UCO Bank (Rs. 450 cr.), Central Bank of India (Rs. 700 cr.) and Vijaya Bank (Rs. 500 cr.).  : Injected Rs. 250 cr. in United Bank of India budget allocates Rs. 16,500 cr. to help maintain Tier- 1 capital ratio of 8%.  IDBI Bank (Rs. 3,119 cr.), Central Bank (Rs. 2,016 cr.), Bank of Maharashtra (Rs. 590 cr.), UCO Bank (Rs. 375 cr.) and Union Bank (Rs. 111 cr.)

Explicit government guarantee Capital injections determined based on PSB funding requirements. Poor performing PSBs more likely to receive GOI support. PSBs receiving capital (except Union Bank) had Tier-1 capital < 8%.  Bank of Maharashtra (6.1%), Central Bank of India (7.0%), UCO Bank (6.5%), Union Bank of India (8.2%), Vijaya Bank (7.7%), IDBI Bank (6.8%). Among the riskier banks.  MES: IDBI (6.67%), Union Bank of India (5.41%),Vijaya Bank (5.02%), UCO (4.26%)  IDBI: Received highest capital injection of Rs 3,119 crores.

Effect on credit growth:

Eventually, full-scale fiscal stimulus stabilized private-sector banks too…

Government-Sponsored Enterprises: United States and India Fannie Mae, Freddie Mac, Ginnie Mae, FHLBs, FHA, … GSEs in the US set up in the 1930’s (Fannie Mae, e.g.) to support housing markets Strengthened over time through newer GSEs “Affordable housing goals” since early 1990’s Implicit guarantee conferred through special status of GSE debt and securities (“flight to safety”) Among the riskier “banks”, especially since 1990’s Financial inclusion goals; Risk-taking on the government put Hard landing in crisis, BUT NOT FOR GSE CREDITORS… Crowding out of private market in mortgages post-crisis

Historical Perspective on US GSEs A brief tour through their history The great depression Privatization in 1968 Securitization & deregulation of mortgage markets in the early 80s FHEFSSA of 1992

GSE Growth – How?

When Did the GSEs Start Taking on “Risky” Mortgages? Source: Fannie Mae

The Sub-prime Securitization Market Took Off: A Race to the Bottom

27 GSEs: Last Mortgage Man Standing Source: SIFMA, CreditSights In $ billions. *2011 YTD through May, 2011

“The shapers of the American mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead they got the ingenuity of government, the security of local banking and the integrity of Wall Street.” - David Frum (columnist, and former speechwriter for President George W. Bush), National Post, July 11, 2008

Finance Reform in the US and India General agreement that a mostly private mortgage market in the United States is the right way to go. But… How do we get there from here? Such a transition was left to private forces in 1990’s and 2000’s Outcome was not an efficient one Lack of level-playing field created perverse downward spiral A similar transition is being (possibly) envisaged in India Expand private sector firms; greater variety; greater scope; freer branching But should we be concerned about lack of level-playing field? Why not privatize the PSBs, improve prudential regulation across board, and manage the transition better