Bank recapitalisation is painful, but necessary

India’s state-owned banks need a government bailout. The country’s wobbly public sector lenders require around $45 billion to put their balance-sheets on a firmer footing, according to a Breakingviews calculator. That’s a bill the new government can ill afford.

But if it acts fast, it may be able to take advantage of the post-election euphoria to persuade private investors to put up some of the cash.

A recent report from the central bank described India’s 21 public sector lenders, which include State Bank of India, Bank of Baroda and Punjab National Bank, as “fragile”.

That’s the polite term. Several years of slow growth have strained the industry: bad debts in the whole banking sector reached 4.4 per cent of total lending at the end of December, up from 3.7 per cent a year earlier. For state-controlled groups the figure is closer to 5 per cent. And that’s just the dud credits they own up to. Public sector banks, which account for three-quarters of India’s total lending, are notorious for rolling over loans to politically sensitive borrowers. The real figure may be as much as twice as large.

Another worry is problem loans which borrower and bank have renegotiated. In the aftermath of the 2008 crisis, Indian regulators gave banks some leeway in how they treated these “restructured” credits. The predictable result is that the loans in this category trebled in three years, reaching Rs 2.9 trillion ($49 billion) by the end of 2013.

That’s greater than the official stock of bad debt. A significant proportion is to borrowers who probably cannot pay.

If these two factors weren’t enough of a headache, India is also raising the bar for how much capital banks must hold. The Reserve Bank of India, the central bank, has interpreted new Basel III rules so that lenders must have Tier 1 capital equivalent to 8.88 percent of their risk-weighted assets by 2018, up from 6.5 percent today.

A new Breakingviews calculator, based on RBI data, shows the size of the potential capital hole. Start by assuming 10 per cent of all loans and 45 per cent of “restructured” loans are duds. Then require lenders to set aside provisions worth 70 per cent of the face value of those loans. Finally, make banks hit the higher 2018 threshold for Tier 1 capital today. In this admittedly harsh scenario, India’s state-owned banks would need more than $45 billion of capital – more than half of their existing equity base.

Stock market listings

The government is on the hook for most of this. Though many public sector banks have stock market listings, the state is legally required to maintain a majority stake. Prime Minister Narendra Modi’s new administration may eventually try to ditch that rule, but only if it can get a bill past the upper house of parliament, which it does not control.

The new administration is unlikely to welcome the idea of pumping in more than 2 per cent of GDP into the financial sector. But delay will only make matters worse. The longer that banks hide past mistakes, the fewer new loans they will make. That will restrict the flow of credit, limiting the economy’s capacity for growth, and making the bad debt problem larger.

The government can take steps to minimise the final bill. A large chunk of the bad loans are to infrastructure projects – particularly power plants – that are in trouble partly because they lack the necessary permits. If the new authorities can clear these bottlenecks, some of the bad debt may eventually turn good.

The most promising way to reduce the cost to Indian taxpayers, however, is to bring in the private sector. Institutional investors may be reluctant to buy more common equity while the government is still in control.

However, banks could issue other forms of capital, such as preference shares, or bonds that are written down in a crisis. India’s recent stock market rally will help: the S&P BSE Bankex index is up 34 per cent so far this year.

Over time, state-owned banks will need more thoroughgoing reform. Many are inefficient and run according to political rather than financial priorities. A wave of consolidation, led by stronger players, could help.

But no amount of restructuring or improved governance can compensate for a shortage of capital. If the new government acts quickly, it could set off a positive feedback loop whereby an improved supply of credit feeds faster economic growth. Delay, and the final reckoning will only be more painful.

( The authors are Reuters Breakingviews columnists. The opinions expressed are their own.)