Since the government cannot privatise public sector banks, the central bank should force it to let the bad ones fail, says Arvind Subramanian, senior fellow, Peterson Institute for International Economics and Centre for Global Development.
The past is never dead. It's not even past," noted the American novelist William Faulkner. Arguably, the two most egregious economic policy mistakes of the past that continue to haunt India were the licensing of Indian industry during the Nehru years and the nationalisation of private banks by Indira Gandhi in 1969.
These actions had one common disastrous feature: penalising and expropriating the Indian private sector.
Other policies that turned out to have adverse consequences were different in principle.
They at least purported to help the private sector (such as the imposition of trade barriers to protect industry from foreign competition) or fill in for it (such as the creation of the public sector).
Restrictive industrial licensing policies have been almost completely reversed, although their consequences still linger (most notably in the weak performance of Indian manufacturing).
But bank nationalisation endures as a millstone around the Indian economy, a grim reminder and legacy of Indira Gandhi's policies.
Undoing this legacy may well turn out to be one of the most critical tasks for the Reserve Bank of India's (RBI's) current governor, Raghuram Rajan.
The problem is so intractable and so embedded in Indian politics that only he can, and can afford to, take on the challenge.
On the face of it, that task has begun. The RBI will soon be awarding new banking licences to allow for a greater role for private sector banks. But this may not be enough. Consider why.
Since 1991, an overarching principle for eliminating inefficiency in vast parts of the economy has been this: to promote competition via private sector entry rather than change ownership through privatisation. This approach had some intrinsic merit - after all, Russia went from communism to gangsterism because it sold public assets cheaply to a few oligarchs.
More importantly, the entry-favouring approach had the virtue of political expediency. Privatising public sector companies would have encountered significant opposition from their managers as well as from strong unions.
Allowing private sector companies to enter the market without touching the public sector incumbents bypassed some of these costs and allowed reform to proceed by stealth. The logic and hope, of course, were that a vibrant private sector would grow rapidly while the public sector would shrink, at least in relative terms.
And the strategy broadly worked. Yes, Air India is still a mess and a public burden, but the Indian aviation and telecommunication sectors of today are mercifully - and unrecognisably - different from what they were 20 years ago, with enormous benefits for the Indian economy. Public sector companies now account for a small share of the overall size of these sectors.
This entry-favouring strategy was tried in banking too. Since the early 1990s, a number of new banking licences were given to the private sector - think of ICICI, HDFC, Axis Bank, Kotak Mahindra, Yes Bank, and so on. Yet, the share of public sector banks in total banking (measured as a share of assets or deposits) has stubbornly persisted around 75 per cent. And the reason is simple.
The private banks have grown, but the public sector banks have grown too because India's politicians have used them as a way to channel money to private sector operators ---often very influential ones. The credit boom of the 2000s, which is now manifesting itself in rising non-performing loans, emanated mostly in the public sector.
Vijay Mallya did not borrow from private banks; he was enabled into borrowing from, and undermining, the public ones. So, going forward the fact of more private banks is no guarantee of reducing the role of public sector banks.
This will be especially true if the new banks are encumbered with regulations such as priority sector lending, which restricts their ability to grow.
So, as new banking licences are awarded, the aim should be to tilt the playing field as much as possible against the public sector incumbents in whose favour the playing field is already hugely tilted by way of unlimited financial support from the public exchequer.
One possibility relates to foreign banks. It is true that the world over - and especially in the United States - regulators are forcing foreign banks to create subsidiaries in host countries so that they will have more capital to cushion against crises.
But in India the benefits of subsidiarisation must be weighed against the costs of deterring foreign bank entry, which might have other benefits such as being able to effectively compete and out-compete public sector banks.
What can be done more directly to reduce the role of public sector banks? Because such banks are important levers of political control and influence, and because bank unions remain powerful, explicit privatisation seems off the table.
But there is an indirect way of privatising them, or at least beginning the process of privatisation, which the RBI should seize. And the opportunities could present themselves soon.
As growth declines and exposes the fragility of some of the public banks in the form of rising non-performing loans, the RBI should be brutal in its assessment of them, erring on the side of declaring some banks as unviable commercial institutions.
The government will want to bail out the failing banks through fresh capital infusions.
But here is where the RBI should stand firm, urging the government to let them go, on the grounds that a fragile economy can afford neither the fiscal costs of bailouts nor the efficiency costs of bad banks continuing to be prolonged on life support.
The worse the economy, the more the bargaining chips Dr Rajan will have. And he should use them to resolve the bad public banks, in part by transferring their good parts to the private sector.
This strategy may sound difficult to implement. Indeed, it will be. But it is the only way forward. The past two decades have taught us that private banks cannot really grow unless and until public sector banks are shrunk.
That shrinking may have to be achieved by allowing the bad public sector banks to fail because politics will never allow good public sector banks to be privatised.
It was famously said that in science progress is made one funeral at a time. Unfortunately, that may be the only realistic way of reforming Indian banking too.