Recapitalization of Banks: The Unfinished Agenda

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Modi government finally recognized the critical health of Public Sector Banks (PSBs) due to rising Non-Performing Assets (NPAs) and announced much-needed recapitalization amounting to INR2.1L cr.

Equity markets as expected showed their support by spiking the market capitalization of 22 listed PSBs by INR1.2 L cr the very next day. The announced package is structured in three tranches. INR18,000 cr will come directly from budgetary allocations. Another INR58,000 cr will be raised by PSBs themselves…presumably via the sale of non-core assets. It is to be noted that Indradhanush (an existing government program) already included these ideas but perhaps not at such a scale.

The new announcement, however, had a third element comprising INR1.35 L cr to be raised through recapitalization (recap) bonds. Implementation for the moment remains unclear. PSBs, flushed with liquidity post demonetization, is likely to buy these recap bonds, the proceeds of which would be re-injected into banks by the government as equity.

Hence PSBs in a way would finance their own bail-out. Cleaner balance sheets make banks more attractive for private investment, also enabling them to focus on fresh lending. The move will boost bank capital ratios, thereby giving them more leeway in expanding credit without worrying about regulatory pressures.

This is important as, under Basel III norms, the minimum level of tier 1 capital has been mandated at 10.5%. In fact, last year when RBI eased the classification norms of tier-1 capital and allowed banks to revalue their assets as per new guidelines, most including the largest lender SBI, could not secure the 10.5% mark.

Recapitalization is a quintessential move to restore the beleaguered sector – plagued by rising NPAs, deteriorating asset quality, and historically low credit growth.

Gross NPA in PSBs rose from 5.43% of advances in March 2015 to 13.69% as of June 2017. In 2015, banks needed recapitalization of INR2 L cr to handle the challenge. Since bad loans have sharply risen since then, the current allocation stands inadequate vis-à-vis the estimated INR3 L cr plus requirement as per Fitch.

It is to be noted that most part of the infused capital will be utilized for higher provisioning or debt write-offs, limiting the possibility of inorganic revival in credit. Also, propensity to lend (supply) need not straightaway translate into a propensity to borrow (demand). Given recap bonds would crowd out private investment and large-scale investors have a sluggish credit demand; targeted lending to MSMEs could revive the credit cycle.

One of the biggest challenges of the recapitalization plan is the possibility of a rise in debt to GDP ratio, which at 69% already indicates higher levels in comparison to other Emerging Market Economies.

Though the Economic Survey suggests bringing debt to GDP ratio to sub-60%, the current proposal makes its achievement difficult. It would be interesting to see how rating agencies respond to this probability.

Coming to the fiscal debate, Chief Economic Adviser Arvind Subramanian says that the true fiscal cost of issuing bonds worth INR1.35 L cr would range between INR8,000-9,000 cr in the form of interest cost.

Unlike the accounting norms of International Monetary Fund (IMF), Indian standards require the inclusion of interest payments on recap bonds in its fiscal expenditure. Restructuring accounting norms as per IMF will be a possible way to save oneself from breaching the budgeted fiscal deficit target of 3.2%.

The fiscal cost could go higher in case the bond market witnesses sustained yield spikes as was seen in 2009 due to oversupply. To illustrate, the 10-year Indian generic bond yield rate which was at 6.75% on October 24 has already touched the peak rate of 6.89%.

The idea of recap bonds has been executed in other economies such as USA, UK, and Indonesia in the past. In the 90s, India itself issued recap bonds to rescue the financially stressed oil marketing companies. Indonesia issued them after the ‘98 East Asian Crisis resulting in the collapse of its banking and financial sector.

Taking a cue from low international interest rates, Indonesia revised its strategy in 2004 by issuing Dollar dominated bonds in International markets. India could have considered this option as besides from facing a lower interest charge, our comfortable external debt position gives more room to increase leverage Internationally.

Also, the problem of crowding out of private investment would reduce. The government has the option to issue “Masala Bonds” (Rupee dominated bonds issued abroad) to hedge any exchange rate risks. Probably the expectation of a rate hike by US Fed in December made the government shy away from this strategy.

The whole exercise brings the problem of moral hazard to play as any write-offs give wrong incentives to defaulters. Case in point is Essar Steel, where promoters bid to buy back the company after receiving write-offs, ironically after filing for bankruptcy. Therefore, the banking management must be vigilant to write off only genuine cases instead of inadvertently assisting willful defaulters.

The success of recapitalization eventually depends on financial prudence shown by bankers while allocating proceeds for provisioning, write-offs or fresh credit disbursal. Transparent decision making accompanied by lower turnaround time would be key. Further, recapitalization must accompany a stream of other measures such as consolidation, governance changes and the eventual creation of a bad bank.

The market has wholeheartedly welcomed the move, but it would be interesting to see whether the Finance Minister would take the initiative to its logical conclusion i.e. a revived & healthy banking sector in India.

The article was originally published at Transfin.

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