The whys and hows of PSU bank recapitalisation

Mumbai: The Indian government and the country’s central bank are at the final stage of drawing up a plan to infuse Rs2.11 trillion capital into public sector banks (PSBs) which roughly have a 70% share of the assets of Indian banking industry, consisting of 21 public sector banks, 26 private sector banks, 43 foreign banks and 56 regional rural banks. Of this, Rs1.35 trillion will come from the sale of so-called recapitalisation bonds and the remaining Rs76,000 crore will be through budgetary allocation and fund-raising from the markets.

Is this big money? It is large—some 1.3% of India’s gross domestic product (GDP). In the past 31 years, between 1985-86 and 2016-17, the government had infused much less, some Rs1.5 trillion in state-owned banks. This puts in place the enormity of the latest bank recapitalisation plan. What is interesting is the present government and the Reserve Bank of India (RBI) do not want to treat this as a dole, as was in the past; they seem to be keen that banking reforms and recapitalisation must go hand in hand.

We are not aware of the process and the basis followed in the first two decades of bank recapitalisation, but in the period between 2008-09 and 2016-17 when the government infused cumulatively Rs1,18,724 crore in PSBs, money was there for the asking. Neither linked to the banks’ performance nor efficiency, it has been a classic story of ad-hocism and absence of any accountable policy guidelines.

The taxpayers’ money has been simply pumped in just to keep PSBs alive. Such kind of capital infusion ideally should be need based; the available records, however, seem to reveal a cocktail of whims and fancies of executives in power that defies any logic.

To put the story of bank recapitalisation in context, capital is core to banks for expanding credit, earning interest and growing their balance sheets so that they can drive economic activities. The government is the majority owner of PSBs in India. The statutory requirement in the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980, and the State Bank of India Act, 1955, ensure that the Indian government shall, at all times, hold not less than 51% of the paid up capital in such banks.

In 2010, the Cabinet Committee on Economic Affairs (CCEA), after taking into account the trends of economy, had decided to raise government holding in all PSBs to 58%. The objective was to create a headroom and enable PSBs to raise capital from the market when they need, without compromising their public sector character.

Subsequently, in December 2014, CCEA decided to allow PSBs to raise capital from public markets through instruments such as follow-on public offer or qualified institutional placement by diluting the government holding up to 52%, in a phased manner. However, besides direct government holding, the Life Insurance Corporation of India (LIC) holds significant stakes in PSBs. As on 31 March 2017, LIC’s stake varies from 3.14% (Indian Bank) to 18.91% (Corporation Bank) over and above a few public sector undertakings, including some of the peer banks, who also cross-hold PSB shares. This ensures indirect but complete government ‘control’ over all PSBs. Since March, LIC’s stake in some of the banks have risen further. For instance, in State Bank of India, its stake has gone up from 8.96% to over 10%.

Drivers of bank recapitalisation

The regulatory requirements of capital adequacy and credit growth are the two main drivers for bank capitalisation. The regulatory architecture is globally framed by the Basel Committee on Banking Supervision—a committee of bank supervisors consisting of members from representative countries. Its mandate is to strengthen the regulation, supervision and practices of banks and enhance financial stability.

So far, three sets of Basel norms have been issued. The Basel I norms were issued in 1988 to provide, for the first time, a global standard on the regulatory capital requirements for banks.

The Basel II norms, introduced in 2004, further strengthened the guidelines for risk management and disclosure requirements.

This called for a minimum capital adequacy ratio (CAR)—or, capital to risk-weighted assets ratio (CRAR) as it is the ratio of regulatory capital funds to risk-weighted assets—which all banks with an international presence were to maintain.

These norms were revisited again in 2010—known as Basel III norms—in the wake of the sub-prime crisis and large scale bank-failures in the US and Europe.

Basel-III emphasized on capital adequacy to protect shareholders’ and customers’ risks and set norms for Tier I and Tier II capital.

The Tier I capital, or core capital, consists mainly of share capital and reserves; Tier II capital, also known as supplementary capital, consists of certain reserves and specific types of subordinated debt.

RBI has adopted Basel II and set the norms for all commercial banks, including PSBs, a notch higher in accordance with its usual cautious approach.

Broadly, the assets of a bank generally carry three categories of risks: credit risk, market risk and operational risk, apart from other associated risks.

Based on the riskiness of the asset, a specific risk weight is assigned to it and the asset value is adjusted as per the risk weight—the risker the asset, the higher the risk weightage and the lower its value. In India, RBI prescribes risk weights for different assets and sectoral/individual industry exposures. For instance, the risk weight on a government bond is zero, but it could be as much as 100% for banks’ exposure to real estates.

There has always been a time-gap in the adoption of the Basel norms in India. For instance, Basel I norms (1988) were adopted in 1996, Basel II norms (2004) were adopted in 2008 even as the transition to Basel III norms (2010) commenced in September 2013 and is expected to be complete by 31 March 2019.

The Basel III norms are a comprehensive set of reform measures to strengthen the regulation, supervision, risks and capital management of the banking sector that evolved after the global financial crisis of 2008.

RBI has always been a conservative central banker, and its norms have mostly been more stringent than the Basel norms. For instance, against the Basel norms of minimum CRAR of 8%, RBI prescribed a 9% CRAR for Indian banks. At present, the minimum CRAR prescribed by RBI is 9%; in addition to that, banks are required to have 2.5% capital conservation buffer—mandatory capital that banks are required to hold in addition to other minimum capital requirements.

The implementation of Basel III norms is coinciding with the subdued economic growth in India and the rising bad assets of banks. Banks do not earn any interest on their non-performing assets, or NPAs; on top of that, they need to provide for them or set aside money, which could have earned interest if lent.

This has been bleeding PSBs, leading to losses at many banks and eroding their capital base and restricting their capacity to lend to make profit. Two main indicators of the performance of banks, among others, are return on assets (RoA) and return on equity (RoE). RoA indicates how profitable a bank is, relative to its total assets; it measures the efficiency of utilizing the bank assets to generate profit and is worked out by dividing net income by average total assets. A higher RoA indicates a better managed and more efficient bank. The profit, when ploughed back, adds to capital, and also improves a bank’s ability to access the markets for additional funds for the purpose of further lending.

RoE, on the other hand, reflects a bank’s efficiency to utilize its shareholder’s funds. A higher RoE also adds to the capital of the bank through reserves and surpluses. A higher ratio indicates better management of shareholder capital and a low or negative RoE reduces the ability of the bank in tapping the capital markets to raise additional funds to meet its regulatory capital needs.

RoA of PSBs has been consistently lower, compared with other scheduled commercial banks, while RoE of PSBs has been lower since 2012-13. In 2015-16, both RoA and RoE for most PSBs have been negative, indicating a loss to the banks and a concern for the government.

After a high credit growth rate regime during the expansionary phase of 2004-07, in tandem with India’s high economic growth rate, the advances of public sector banks between 2008 and 2016 have more than doubled from Rs22.59 trillion to Rs55.94 trillion even though the rate of increase in advances has tapered in recent years—2.14% rise in 2015-16 against 19.56% in 2009-10.

The rise in advances, coupled with the stringent capital adequacy requirements imposed by RBI in the wake of the Basel III norms, high levels of NPAs and the poor performance of PSBs have led to significant capital erosion and requirements for further capital—both for replenishment of the base eroded by NPAs and fresh ones for giving loans.

The capital can come either from their dominant shareholder (the government of India) or the capital market. Their underperformance and the pile of bad loans leading to low book value come in the way of accessing the capital market. There is a significant gap between the book value and market value of PSB shares, with most PSBs having a lower market value, compared with their book values. Hence, the government as the majority stakeholder needs to step in to rescue PSBs. However, the norms followed for capital infusion seem to be inconsistent, ad-hoc and piece-meal, lacking any consistent policy pattern.

This is the first of a three-part series on bank recapitalisation.

Tamal Bandyopadhyay, a consulting editor at Mint, is adviser to Bandhan Bank. His latest book is From Lehman to Demonetization: A Decade of Disruptions, Reforms and Misadventures.

Achintan Bhattacharya is a former civil servant and former director of the National Institute of Bank Management, Pune.