Lessons from past bank troubles
Wisely used, bank crises can give opportunities to shareholders to make good returns at the time of peak pessimism
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Here is how Vulcans* would run their banks and handle bank crises. A bank in trouble would be liquidated. All assets would be realised. Depositors would be paid from the asset realisation. If the depositors got their deposits in full, the surplus left would go to shareholders of the bank. In case of a shortfall, Deposit Insurance and Credit Guarantee Corp. would pay up to ₹ 1 lakh to each depositor to cover the shortfall and the shareholders would get nothing. (*Humanoids from planet Vulcan. Mr. Spock of Star Trek being the most famous one. They are characterised by their rationality and complete lack of emotion.)
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On planet earth, we do banking differently. It is said that “History does not repeat itself but it does rhyme". So, while we do not know the future, it may be instructive to look at the past actions of governments and central banks on earth to have some understanding of how the future will pan out for banks in India.
No government or central bank likes a systemic banking crisis. Even the strongest proponents of free market capitalism yield when it comes to saving bank depositors as we have seen in the US in 2008 and 2009. In India, where public sector banks have the most market share, depositors have the least to worry. Governments and central banks have concluded (and rightly so) that the costs on the economy far outweigh the costs of bank bailouts and, thus, do not like bank failures. Those who hold shares of listed companies in India are not a large enough vote bank and usually the government or the central bank would not worry too much about them. But in the case of public sector banks, the government itself is a majority shareholder. Also, letting shareholders take a hit would mean that the message goes out loud and clear to the public that the bank is in trouble, which is not what they want to do.
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Wisely used, bank crises can give opportunities to shareholders to make good returns at the time of peak pessimism. Let us look at some of the means of bank bailouts.
Widen credit spreads: When the banking system goes through a credit crisis, credit becomes difficult to obtain. (Look at the shift from corporate bond funds to gilt funds in the Indian mutual fund space after the Amtek crisis). While interest rates in the deposit market, money market and on government bonds come down, lending rates to corporate borrowers and households remain at elevated levels.
This results in high yield spreads for banks, which use the higher income to write off bad loans over a period of time. The interesting point here is that this benefit comes to all banks whether the bank is in trouble or not. So, this may be helpful for the better quality banks.
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Treasury bond gains: In the last cycle, interest rates on 10-year government bonds had fallen to sub-5% levels and banks had used treasury gains to write off a lot of accumulated credit losses.
Fund infusion or book entry recapitalisation: The markets were somewhat disappointed with the level of funds the Budget provided for recapitalisation of public sector banks. In the past, the Government of India has issued special bonds to banks in return for equity. This provides equity capital to the banks without resorting to market borrowing and crowding out the private sector. It is possible that something similar could be used if the need arises.
Bad bank or Troubled Asset Relief Program (TARP) like schemes: In order to free banks from the legacy of bad assets, asset reconstruction companies (ARCs) or Special Purpose Vehicles could ramp up purchases of assets from troubled banks. There was a lot of reference of this in the Budget speech.
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Shotgun marriages: This has been a standard playbook for regulators the world over. Whether it is the JP Morgan acquisition of Bear Stearns or the Bank of America acquisition of Merrill Lynch or our own acquisition of Global Trust Bank by Oriental Bank of Commerce, it is one less problem for the regulators. In this Budget, there has been some mention of consolidation and it remains to be seen in what form it comes about.
However, the interesting part from shareholders’ perspective is that usually shareholders of the stronger bank lose out and those of the weaker bank get some bailout (in some cases). Because of this, it may not be prudent to invest in public sector banks as you never know which bank will get merged into it in the near future.
Asset sales, restructuring, cost cuts: This happens at the borrowers’ end as well as at the banks’ end. We have seen asset sales by over-leveraged groups in India to pay for debt. At the same time, we could see banks selling non-core assets such as stock exchange shares, depository shares, mutual funds and insurance arms, and so on, to generate profits and to free up capital. This has been seen in the case of international banks also. It is important to note that all gross non-performing assets (NPAs) are not a loss. A substantial portion of NPAs can be recovered over time.
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Just enough stress: It is to be remembered that the regulators and the government want a clean-up; they are not looking to topple banks. So, while in one quarter you would see additional provisioning on account of inspections or advice by the central bank, in the other quarter, you would see measures such as allowing banks to revalue real estate assets and use that value for capital adequacy. Even if a dead bank is allowed to function, the future profits could be used to write off past loans.
Banks that are not likely to be subject to ‘shotgun marriages’ and whose NPA problems are relatively low, may make excellent investments provided entry valuation is right.
Rajeev Thakkar, chief investment officer and director, PPFAS Asset Management Pvt. Ltd.
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