Any strategy to deal with the worsening banking crisis involves the three stages of recognition, resolution and recapitalization. The third element has not yet got the attention it deserves in public debates. Reserve Bank of India governor Urjit Patel did well last week to highlight the need to bolster the capital of the Indian banking system. Extra capital will be needed when banks take large haircuts to bring the book value of the problem loans closer to the economic value.
Two issues deserve mention in this context. First, the money that has been provided till now by the government in the budget is inadequate. So will the government create fiscal space to make a massive bank recapitalization possible? Or will it fall back on financial engineering by floating recapitalization bonds that banks subscribe to?
Second, will money be given to public sector banks depending on their immediate capital needs or on the quality of governance? In other words, will good money be thrown after bad? The government should not create conditions for adverse selection.
There is a long battle ahead.