Dear FM, please attach strings to bank recapitalisation

While announcing the big fat recapitalisation of banks, any government, anywhere in the world, is bound to face the predicament of Larry Fortensky. On his wedding night at Michael Jackson’s Neverland Valley Ranch at Santa Barbara County, California, in October 1991, Fortensky—Elizabeth Taylor’s seventh husband from her eighth marriage (she had remarried Richard Burton)—knew what exactly he was expected to do, but his challenge was how he could do it differently from the past husbands of much-married Taylor.

How could India’s finance minister Arun Jaitley be different from his predecessors who have, since 1994, continuously thrown lifelines to many failing banks, using tax payers’ money. Jaitley’s over-Rs2 trillion bank recapitalisation package, announced last week, is the largest “bailout” in Indian banking history.

Most analysts are gung-ho on India’s plan to pump so much money—more than one-third of the core or tier I capital (equity and reserves)—into state-owned banks. Investors too have sent a strong signal of their approval.

Reacting to the Rs2.11 trillion bank recapitalisation over a period of two years, the market value of state-owned banks zoomed Rs1.2 trillion in one day.

There are three components in the bank recapitalisation package that roughly accounts for 1.3% of India’s GDP—the government will directly pay banks Rs18,000 crore by buying their shares; another Rs58,000 crore will be raised from the market; and Rs1.35 trillion (equivalent to 0.9% of GDP) is expected to come from recapitalisation bonds.

We do not know as yet who will issue the recapitalisation bonds (the government or a special purpose vehicle that can be floated for this purpose), the maturity of such bonds and the coupon. Whether they will add to the fiscal deficit or not will depend on who is issuing the bonds, and what kind of instrument it is. However, the interest outgo on the bonds is likely to add to the deficit, since the government will pay that. At current market rates, the annual interest cost for the government would be about Rs9,000 crore—less than 0.1% of the GDP.

Under International Monetary Fund norms, recapitalisation bonds are not added to the accounting of the fiscal deficit as they are squared off by buying shares in banks. In India, however, such bonds in the past were taken into account since the government pays interest and eventually redeems them. If they are issued by quasi-government institutions, such bonds will be treated as contingent liabilities of the government.

The first tranche of recapitalisation bonds was issued by the Indian government in 1994. In the 1993-94 Union Budget, the then finance minister Manmohan Singh announced “provision for a large capital contribution of Rs5,700 crore to the nationalized banks” to protect “the viability and financial health of the Indian banking system”.

In the same budget, Singh announced the government’s decision to allow State Bank of India and other nationalized banks to access the capital markets for raising fresh equity, even as the government would “continue to retain majority ownership, and therefore effective control” in these banks. The next budget (1994-95) provided another Rs5,600 crore as additional capital contribution for these banks in the form of government bonds. On both occasions, there was no immediate fiscal burden but the government bore the interest cost.

After the 2008 global financial crisis, the first signs of stress in Indian banks were seen in 2010 and since then, the government has pumped in Rs67,734 crore capital to keep the public sector banks running, apart from the Rs70,000 crore fund infusion plan under the so-called Indradhanush plan, over a period of four years between 2016 and 2019.

Of this, Rs52,000 crore has already been infused. The remaining Rs18,000 crore has been included in the latest package. The Indradhanush plan (announced in August 2015), also outlined Rs1.1 trillion being raised by the banks from the market. Of this, the banks till now have raised a little over Rs21,000 crore. The government expects them to raise Rs58,000 crore in next two years. If the enthusiasm of the investors is anything to go by, none would dare to dub it as too ambitious a target.

There is no doubt that the massive recapitalisation plan will help banks clean up their balance sheets, but will it fuel credit offtake and lift the sagging growth in Asia’s third largest economy? Even if the answers to both these questions are in the affirmative, is this the last of the bailouts for Indian banks? In other words, besides taking care of the stock of toxic assets, will it stem the flow of such assets in Indian banking in future?

Highlighting the plight of the Indian economy grappling with its twin balance sheet problem—over-leveraged companies and bad-loan-laden banks—the Economic Survey 2016-17 has mentioned that more than four-fifths of the NPAs are in the public sector banks, where the NPA ratio had reached almost 12% of loans in January 2017. This is higher than any other major emerging markets, with the exception of Russia. Since then, the pile of bad loans has risen further.

The stressed loans of the banking system—including NPAs and restructured loans but excluding written-off loans—are now at least Rs9.5 trillion or 12.6% of the overall credit portfolio of Indian banks (all banks have not announced their September quarter earnings as yet).

Even though roughly one-third of the bad assets have already been provided for, banks are expected to use much of the recapitalisation money to clean up their balance sheets. The package will encourage them to aggressively set aside money and take deep haircuts for resolving the bad loan problems. Besides, the capital will also be used to meet the international Basel III norms that will kick in by April 2019.

Indeed, rising bad loans have created a fear psychosis among public sector bankers and they aren’t too willing to lend but the bank recapitalisation package is unlikely to revive growth overnight, as the lack of demand for credit is a far bigger problem than banks’ ability to lend at this point.

In fact, this is why the government could delay the capital infusion. Had the banks been flooded with new loan proposals, the recapitalisation announcement would have come much earlier. The capital infusion will, of course, help the government-owned banks fight it out with private banks and non-banking financial companies for their share of loans. Also, even though the large corporations do not have big investment plans, the micro, small and medium enterprises are looking for money and the government-owned banks will be able to support their credit demand.

While announcing the first bank recapitalisation plan in the 1994 budget, Singh had said: “While undertaking such a large injection of capital into the banks, specific commitments will be required from each bank to ensure that their future management practices ensure a high level of portfolio quality so that the earlier problem does not recur.” Had the government stuck to this, we would not have seen recurring bailouts of Indian banks.

Jaitley has indicated that the government will use discretion while allocating capital to banks. He has also said that a series of banking reforms will accompany the capital infusion. Reserve Bank of India governor Urjit Patel has said those banks that have worked harder to deal with their problem loans will get priority in access to fresh capital. I hope that both Jaitley and Patel will walk the talk. If we want this to be the last of the bailouts, the government must not be democratic in the distribution of capital. And, many strings must be attached to this lifeline. Only the efficient banks should get it.

There is no need to keep some of the banks alive to collect public deposits and buy government bonds; if they do not know how to handle credit, they have no business to be around as banks’ primary job is to give credit and support the economic growth using savers’ money.

Many research houses are dubbing the recapitalisation plan as India’s TARP (Troubled Asset Relief Program) moment. In October 2008, the US Treasury announced up to $700 billion TARP to save its privately managed banks from the so-called subprime mortgage crisis in the thick of the global financial turmoil. By December 2014, when the programme ended, the government had invested $426.4 billion but recovered more—some $441.7 billion. Will the revitalized banks in India be able to pay back to the government? They can, if the government follows up with reforms in state-owned banks, which have been pending for long.

The Rs2.1 trillion recapitalisation package is only half the story. I would love to hear Jaitley telling the bankers “Mere dost, picture abhi baki hai” (My friend, the story is not yet over) and unveiling the reforms package soon after the contours of the recapitalisation are in place.

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck, Sahara: The Untold Story, and Bandhan: The Making of a Bank.

His Twitter handle is @tamalbandyo.

Comments are welcome at bankerstrust@livemint.com.

Read Tamal Bandyopadhyay’s earlier columns at livemint.com/bankerstrust