Is the recapitalisation bond a panacea?

As a part of its parenting process, the government has decided to infuse funds into the banks  through  three different methods to improve the balance sheet. As the biggest shareholders in PSBs, the government has shouldered the responsibility of infusing capital lest the banks should face a liquidity crunch.

Now the pile of NPAs is more than 10% of the banks' loan portfolio, ironically larger than the GDP of many countries. The Rs 2.11 lakh crore of capital infusion is planned in three parts.

The government will directly pay the banks Rs 18,000 crore by buying their shares. Encourage banks to raise Rs 58,000 crore from the market, Rs 1.35 lakh crore through recapitalisation bonds. The government still is not clear about the mechanism of these bonds though it seeks to off-set the damage caused to the PSBs by giving them more capital.

Recapitalisation bonds issue looks to be an intelligent way of doing the same thing in a different way. Since the government is not apparently infusing money from its treasury, it does not seem to have an immediate impact on fiscal deficit.

Recapitalisation bonds are bonds lent by the government to the banks to raise money from the market with a promise to repay the face value on the maturity date and periodic interest.

The banks will give this money to the government which will in turn buy shares in these banks.

According to Chief Economic Adviser Arvind Subramanian, the government would be liable to pay the interest and face value of the bonds, which would be about Rs 9,000 crore (given 7% rate). Hopefully, this cost for the government will spur economic activity due to increased credit. It is in fact a ceteris paribus situation, which is used in economics to rule out the possibility of other factors changing.

The banks may use these funds obtained by writing off bad assets, or strengthen their balance sheet (tier 1 capital) as per Basel III norms. These bonds are held as investments under HTM (held till maturity) category and will not be included in the LR category. Hence, an important point to note is that such securities cannot be traded.

Increased financial strength shown by the bank balance sheet through recapitalisation does not mean augmentation of credit deployment by banks. Credit deployment is necessarily a function of many variables and one must remember there are many other alternative sources of finance to the borrowers if not PSBs.

But is this approach, targeting the actual problem of NPAs? A point to ponder here is recapitalisation is not the only solution for the problem of NPAs.

We have just seen the tip of the ice berg and the mounting of NPAs shall persist despite this recapitalisation exercise.The government couldn't leave the PCA (banks under Prompt corrective Action) banks to starve for capital, to maintain the public confidence and reassure depositors.

The negative side of it is that it may send a wrong message to both the borrowers and lenders that the government will come to the rescue of PSBs and never allow them to fail despite their indiscriminate lending and not mending their errant ways. Moreover, the Insolvency and Bankruptcy code is being put to use aggressively, used to free up funds of banks stuck in insolvent companies.

Recapitalisation has become a tradition since 2010. But, how long can the government continue this parenting and hand holding? At what cost? The government has still not revealed the mechanism of how these bonds work. The designing of the bonds is a very crucial determinant of the financial performance of PSBs and determine the success or failure of the recapitalisation effort.

The government has imposed a restriction on tradability of these bonds. This issue can have certain implications on the banks. It can restrict loan growth and the ability to meet liquidity requirements and the government may limit bank's ability to invest in risky investments by doing so. One potential drawback to this approach is that the banks may be liquidity constrained as the bonds are categorised under HTM.

They just sit on the banks' balance sheet hurting lending. Issuing Non marketable securities is a bad idea. Usually bond designs are influenced by consideration related to building of a bond market such as providing a range of maturities or as preferred by investors.

Recapitalisation bonds are designed just for the financial performance of PSBs.

Appropriate bond design can lead to the success of a recapitalisation programme. Banks with insufficient interest income may suffer losses leading to further intervention.

Hence, certain features like no trading restriction, market rates of interest, using floating rates to combat interest rate risk, must be embedded into the bonds. Finally, the features of the bond design need to result in satisfactory financial performance of the recapitalised banks even in little less optimistic scenarios. Otherwise it will lead to a need for further supervisory intervention and draining of public funds into abyss.

(The writer is  faculty member, Institute of Management, Christ - Deemed to be University, Bengaluru)