A few weeks ago, the government announced a Mega Recapitalization Plan of INR 2.1 lac crore for the state-owned PSU Banks.
The plan is split into two parts -INR 1.35 lac crore to be generated via the issue of Recapitalization Bonds and the remaining INR 76,000 crore (which also includes INR 18,000 crore already allocated under the Indradhanush Recapitalization Scheme) via the budgetary support over the next two fiscals.
The capital starved PSU banks have been reeling under the burden of bad loans. This has drastically curbed their ability to reinitiate the flow of credit and push private investment cycle out of its dormancy.
So this announcement came as a big positive surprise for everyone in general and PSU banks in particular.
Many even claimed that the size of the program was equivalent to their estimates of capital requirements for banks for both non-performing asset provisioning and some growth. It is another matter that (in words of CEA Arvind Subramanian), “the amount of stressed assets always and everywhere is at least 10-20 percent more than what it is always and everywhere claimed to be.” So any claims about the adequacy of Recap-Program need to be taken with a pinch of salt.
Then there were many who called this to be an Indian equivalent of the U.S. Treasury’s Troubled Asset Relief Program or TARP, which was created as a response to the 2008 financial crisis.
Irrespective of the view people may have, one thing is clear that this front-loaded commitment brings a much-needed coherence to the resolution process. And for this, the policymakers need to be appreciated.
Before we deep dive let’s first understand the issue at hand in layman terms.
What is this Recapitalization (in simple terms)?
For every loan that a bank gives, it needs to have some percentage as capital. So for example, if this percentage is 10%, the bank then needs to have a capital of Rs. 1000 Cr if it wants to give out loans for Rs 10,000 Cr.
Some loans will obviously go bad. Suppose 4% of the loans, i.e. about Rs. 400 Cr (which is 4% of Rs. 10,000 Cr) go bad. So this loss will hit bank’s capital which will fall to Rs. 600 Cr (Rs. 1000 Cr – Rs. 400 Cr of bad loans) if the loss is realized. This means that bank now has Rs. 600 Cr capital on Rs. 9600 Cr loans - which is around 6.25% and much below the 10% regulator specified limit.
To rectify the situation and improve the ratio, banks need to raise more money, i.e. about Rs 360 Cr to bring capital back to 10% capital ratio (Rs. 960 Cr on Rs. 9600 Cr loans). Or, they need to call back loans worth Rs. 3600 Cr so that existing capital of Rs. 600 Cr is sufficient (as per 10% limit) for the reduced loan base of Rs. 6000 Cr. But calling back loans is of course not possible or practical.
So what happens is that banks stop lending.
And this is exactly what happened with the PSU banks. They stopped lending because they couldn’t lend more as their capital ratios will not allow it any more.
Recapitalization program is trying to solve this. The government gives money as capital to banks so that they can take in some losses and move on with fresh lending.
Let’s get to the actual situation now.
Why is Recapitalization needed now?
It is common knowledge that the quantum of bad loans in the Indian Banking sector is mammoth.
The stressed asset pile is close to INR 10 lac crores. Of this, NPAs account for Rs 7.7 lac crores and the rest are restructured loans. In addition, the banks also need more capital to transition towards the full implementation of Basel 3 norms.
The earlier plan to infuse Rs. 70,000 crore between 2016 and fiscal 2019 was looking increasingly inadequate to meet these capital requirements. To be fair, the government was keen that banks too pitch in and supplement this infusion by raising capital on their own. But due to their toxic books and few other factors (like lack of investor interest), banks found it tough to do anything.
Many felt that these banks should have been left to fend for themselves.
But that was not possible practically. The Indian economy still needs public sector banks as many economic objectives of the government need a strong and unrelenting support of the PSU banks.
Banks themselves switched on their damage control mode and began focusing on their NPAs than on new lending. And while banks started recognizing bulk of these assets as non-performing assets (NPAs), resolution of these assets is not easy and is taking time.
All this, in combination with inadequate credit demand, made for a vicious circle that became unbreachable for many banks.
So what effectively happened was that for several PSU banks, it seemed that they were set on a path of slow death. The government could not afford this -for a variety of reasons. And hence the bank recapitalization plan.
It is expected that this program will allow banks to focus on lending once again and help kick-start growth (which has slowed down since days of high seven percent). Government is also focusing on indirect benefits of such growth, which are more loans to small businesses and consequently, employment generation, etc.
Is it different this time?
Many are of the view that once again, it’s the same old story and things will not change. But let us try to see the bigger picture here.
This is the first time in many years that the government is using a comprehensive strategy to address the issue instead of taking a piecemeal approach.
In a series of development leading to this program announcement, there seems to be an honest intent to address this issue for once and for all.
It began in 2014 when RBI ended the unnecessary permission given to banks to restructure loans indiscriminately. Then in 2015, banks were forced to recognize a bunch of large stressed loans as NPAs, whether or not they were paying interest. Then came the Insolvency and Bankruptcy Code in 2016 that made it easier for creditors to dispossess defaulting promoters and sell the companies or assets to new promoters. Then earlier in 2017, RBI in toe with the government forced the banks to push top 50 defaulters to the NCLT.
And then happened this mega Recapitalization Program.
So it does seem that this time, the overall strategy is better thought out and may provide desired results to some extent. But it is still too early to judge and the problem being addressed is too large to be solved overnight.
But bank recapitalization is not a magic bullet. And things need to be done even beyond this. Ideally, recapitalization and restructuring should go together or atleast not without much lag between the two.
What More is Needed?
One point that is doing rounds is about the moral hazard. That is, what stops these banks from not committing the same mistakes and get into a mess again.
No doubt this is possible.
So even though this recap exercise is a step in the right direction and will help strengthen these banks to some extent, this recapitalization without consolidation and structural reforms is inadequate if not useless. And that is why there is a need to go much beyond this Recap Program.
First of all, not all PSU banks should have access to this program. The government must be selective about which banks get additional capital. Ideally, the banks that have worked harder to deal with their mess should be given priority.
If this means that some of the weaker banks will shrink and eventually become ripe for closure, then so be it. It is not wrong to focus on recapitalizing the strongest 10-15 public sector banks and force the rest to shrink or take their chances with a slow revival.
Unviable banks should be financed only to the extent of their current balances and not for their growth. Of course this will not be easy. But this is what may be necessary now. To implement this, the deposits may be shifted to stronger banks and as far as good assets are concerned, these should be sold off to the stronger banks. The inflow from this asset sale should be used to address bad loans. Eventually, this can result in winding up of weaker banks(hopefully if union issues have been tackled).
Mergers of small weak banks should not happen randomly with larger banks. This will not serve its purpose. There should be a calibrated plan to implement such a strategy. Many are of the view that small banks should go for asset swapping, where smaller banks can sell or swap assets of large companies to larger banks.
We feel that as far as mergers are concerned, they should be encouraged only when the NPA pain is practically addressed and mostly over.
But bigger problems still exist and aren’t addressed by any Recap-Program.
Inefficient and at times politically influenced lending practices, comparatively uncompetitive workforce and slow technology up gradation.
These are the fundamental problems of the PSU banks that have resulted in this mess and still aren’t being addressed correctly.
So even though Recap Program is a lease of life for these banks, the fact is that writing for them is on the wall if these problems are not addressed adequately.
Finally, it is true that at least theoretically, the government had the option of doing nothing about the sorry state of PSU banking space. And with all due respect, it did the right thing by trying to catch the bull by its horn. A large bank recapitalization will pay for itself many times over if things go as per expectations. It might not be easy, but that is still fine given the alternative scenarios that might have played out:
And as ex-RBI governor Raghuram Rajan said:
“I think it’s important to recognize that banks do need capital and you need to put it aside and if it means that there are other resources allocations that should be reduced, so be it. I mean, that’s the cost of staying within the budget. This is not painless.”
But having said that, we reiterate that recapitalization alone is not enough. The government should back this recapitalization program with some real reforms in public sector banks. That is the only way to fully address this problem in the long term.