The hard truth about bank recapitalisation

Across the world, banks are licensed by regulators because they are important pillars of the economy and their raw material is public money. Strict adherence to the rules of the game is therefore an important part of the banking business, and this is ensured by strong regulation and active oversight directed at one aim: public money should be in safe hands.

By this measure, ballooning NPAs in the Indian system tell us one simple story: Indian banks and the regulators have failed to protect public funds. Now filling that huge hole with more public funds, which is what the bank recapitalisation amounts to, is a signal that bad loans are a bad story that we must soon forget, and all will be well again. Among the first and the most enthusiastic to sell this story is the RBI, where Governor Urjit Patel has called it a "monumental step", a "decisive package to restore the health of the Indian banking system". The hard truth is a little different.

Recapitalisation of public sector banks by the government is not a new phenomenon in India, and has been done periodically. In 1993-94, Rs 7,000 crore was infused as recapitalisation. The 'Indradhanush' programme of the present government put up Rs 47,915 crore in two years. But at Rs 2.11 lakh crore - comprising budgetary provisions of Rs 18,139 crore, recapitalisation bonds of Rs 1.35 lakh crore and the balance Rs 58,000 crore by the banks from the market - the number this time is dizzyingly high. Bonds of Rs 1.35 lakh crore sought to be raised are by a rough estimate as high as 1% of GDP. It would be fanciful to claim that this will not impact the fiscal situation and liquidity, as the RBI has sought to argue.

The typical budgetary accounting process makes the receipt and expenditure of these bonds "contra entry", thus ensuring that there will be no net cash outgo and hence no fiscal deficit impact, except for the interest paid to the investors of these bonds. As there is no cash outgo, it is said that there is no liquidity impact. This accounting arrangement is being used to provide solace on the deficit and liquidity front. However, as anyone can see, this is a misleading half-truth.

Eventually, money cannot come out of thin air. The funds have to be arranged from the market by borrowing. Budgetary accounting can protect the fiscal deficit but there will be an adverse impact on the interest rate as the borrowing by the government goes up. This will adversely impact the term structure of the interest rate.

Moreover, we must ask, who will invest in these bonds? The bonds are not eligible for SLR. Therefore, appetite depends on the maturity and interest rate, eventually impacting the interest rate in the entire system, given the huge borrowing that will happen.

The bonds have to be eventually repaid. So, when they mature, funds need to be arranged either by borrowing or from government revenues (both tax and non-tax). Since the latter is difficult, the government will take recourse to borrowing to repay, and the fiscal deficit will go up the year this happens. So, in that sense, this is kicking the can down the road.

Misleading narrative

It will not be out of place to mention here that the RBI was against the farm loan waiver on several grounds, most importantly its adverse fiscal impact on state budgets. Recapitalisation bonds for PSU banks also suffer from a similar adverse fiscal implication for the Centre.

That this is sought to be done through bonds, the so-called "front-load capital injections while staggering the attendant fiscal implication over a period of time" to quote the RBI Governor, is no less burdensome. It is myopic, if not misleading, to refer to a clear case of "quasi-fiscal deficit" in glowing terms.

Moreover, the recapitalisation will help in accounting improvement in the balance sheet of PSU banks but certainly not solve structural problems. Therefore, the promise that fresh capital injection will result in immediate credit creation is not the complete truth, again. Banks are only the suppliers of credit. The cost of credit and delivery of credit are important from the angle of demand for credit.

Currently, the demand for credit by the corporates is also not encouraging as they are faced with the problem of addressing non-repayment of loans. Thus, it is important to revive the weak balance sheets of corporates also. To what extent the implementation of the Insolvency and Bankruptcy Code is helping the corporates resolve their stress remains in darkness.

Some questions stand out. First, whether a strong capital base after recapitalisation will check wilful defaults by the big borrowers? If yes, what is the monitoring mechanism that will be put in place for this? In the absence of strong punitive measures for those who violate the rules and prudent lending norms, both from the side of banks and the borrowers, this is likely to be seen as licence to loot once again.

Further, in the zeal to sell the solution, a tall claim being thrown about is that the recapitalisation of PSU banks has come at a time of sound macroeconomic conditions. Possibly, the authorities have in mind the modest growth and low inflation currently witnessed in India. In order to make sound macroeconomic conditions sustainable, what we need is fiscal space, coupled with effective monetary policy transmission.

Persistence of the revenue deficit at a higher level implies dissaving of the government and acts as a severe drag on capital investment and the movement towards higher growth trajectory. The recapitalisation of public sector banks will further fuel the adverse impact of revenue deficit on growth.

The problems of weak balance sheet and weak capital base are the result of inefficiency and mismanagement of the public sector banks. It also is a typical case of lack of governance. In that sense, recapitalisation offers moral hazard problems and its celebration as a "decisive package" makes a bad situation worse.

The need of the hour is to understand the hard truth about recapitalisation and improve the governance of the public sector banks. At the very least, a lot of heads must roll in return for such a huge injection of funds by the people of India to fill a hole that the people had no hand in creating.

(The writers are faculty members at SPJIMR)

(The Billion Press)

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