Bank recapitalisation: A lesson from 1993, with eye to the future

The economy was in repair in 1992-93 after the famous balance of payments crisis in 1991-92 and the government had to unveil reforms in the financial sector especially after the securities scam of 1991-92.

Written by Shaji Vikraman | Mumbai | Updated: October 26, 2017 7:13:15 am
bank recapitalisation, recapitalisation, sensex, economy, india banks, Arun jaitley, economy growth, India economy, Indian banking shares, NSE, GDP, indian express Stocks of Indian banks on the Sensex were on fire Wednesday

Stocks of Indian banks on the Sensex were on fire Wednesday — surging over 25 per cent on an average after the NDA’s Rs 2.11-lakh crore capitalisation plan for state-owned banks over two years. What may have enthused investors is not just the signal of the government’s approach to resolving the mess in the banking sector by infusing a huge amount of capital but that a good part of this funding will not impact the fiscal deficit with the issue of what is called “recapitalisation bonds.”

It’s an approach which was first tried out almost 25 years ago. The economy was in repair in 1992-93 after the famous balance of payments crisis in 1991-92 and the government had to unveil reforms in the financial sector especially after the securities scam of 1991-92.

For a cash-strapped government then, it meant having to set money aside to help banks which had to make huge provisions against bad loans — over Rs.10,000 crore. To protect banks, Manmohan Singh, who was then Finance Minister, provided in his 1993 budget, Rs 5700 crore to public sector banks. The government then issued bonds to infuse capital into banks — which implied there was no cash outgo for the exchequer — with the government’s liability being the interest payment on the bonds and their final redemption. Since then, this has largely been the route — with some design changes — to provide capital to banks by successive governments.

This time, the government package for banks features the owner of many of these banks — the government — providing Rs 18,000 crore from the budget, with Rs 58,000 crore being raised by some banks from the capital market over the next couple of years and Rs 1.35 lakh crore as recapitalisation bonds. Details are yet to be announced but the way this often works is: In the first leg, the government gives money to banks, and banks, in turn, buy or subscribe to bonds issued by the government at a fixed coupon or interest linked to market rates for a specified period, 10 or 15 years or longer.

This will be counted as Tier One or Core capital of banks, critical to maintaining globally accepted standards of capital for banks which, today, is 9 per cent of their total loans, investments and other assets after factoring in risks against each of these. As banks set aside funds for bad loans, that depletes their capital and inhibits their ability to lend. A government which runs a deficit and is committed to spending on roads, ports and social welfare measures, won’t have the huge amount of cash to infuse as capital for banks. That’s where these bonds come in.

Not only do these bonds help top up capital for banks but interest on these bonds will be an income for lenders. So when growth picks up, they will be in a position to lend afresh after having set aside money for bad loans or after writing off loans.

For the government, what are the costs?

On Rs 1.35 lakh crore worth of recapitalisation bonds, the interest payment outgo could range between Rs 8000 to Rs 9000 crore annually, which may be a small cost to pay in a balance sheet of the size of the government. And it may also not make much of a difference on bond yields or the interest paid on bonds. What are the spin-offs? According to Chief Economic Advisor, Arvind Subramanian, it will be offset by what he calls the “confidence impact” of having addressed this issue of lending, boosting credit supply, private investment and growth. The rest, as he says, is accounting.

The issue is whether these bonds add to the government’s overall debt and to the fiscal deficit with the government having committed to a fiscal deficit of 3.2 per cent in FY18. The CEA has cited standard IMF accounting norms which is that recap bonds do not increase the deficit and that, under India’s convention, these bonds would add to the deficit. RBI Governor Urjit Patel, too, says that it will be liquidity-neutral for the Government.

It is not clear whether these bonds will be marketable or held only by banks (which is more likely) and whether this will be factored in determining the Statutory Liquidity Ratio. That is something more of interest to those in bond markets and for bankers. But, theoretically, this should lead to more lending by banks though the question posed by some is whether banks have resources to lend large amounts? That is countered by some bankers who say there is plenty of liquidity in the banking system.

Will this drive loan demand in the near term? Unlikely, says Neelkanth Mishra of Credit Suisse, because of the low demand for credit now. But what this capital infuson, which he calls a fiscal stimulus, could do, he says, is to ensure a multiplier effect. Which is that even after banks use part of the funds to provide for bad loans, a good chunk will still be available for growth capital. PSU banks, hobbled by bad loans and high fixed costs compared to private banks, will be able to compete better down the line. Indeed, Mishra expects interest rates to fall.

What this calibrated approach, as described by Patel, could do is to allow banks which are in a better shape to be in line for capital infusion first bringing in an element of market discipline compared to the past when banks got capital regardless of their size and health.

As Manmohan Singh said in 1993: “This is the price we have to pay for having tolerated management practices in banks and types of lending which paid inadequate attention to portfolio practices and recoveries…I may add that while undertaking such a large injection of capital into these banks, specific commitments will be required from each bank to ensure that their future management practices ensure a high level of portfolio quality so that the earlier problem does not recur.” These words have a very relevant ring today.

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