The Reserve Bank of India (RBI) top brass has been batting for a number of ways to resolve public sector bank problems. In a lucid speech, deputy governor Viral Acharya suggested options like raising private capital, mergers, and divestments. RBI governor Urjit Patel, in the Third Kotak Family Distinguished Lecture delivered at Columbia University, stated that the system would be better off if public sector banks are consolidated into fewer but healthier banks.
Gross bank credit of public sector banks has been decelerating from 2010. There was a temporary increase in credit of the State Bank of India group from September 2015 to March 2016, but even here the trend is one of decline.
Restoring credit growth is vital for the growth of the economy and today it may be the single most important factor that could inhibit sustained growth. An important contributing element to this situation is the high level of stressed assets in the banks combined with little bank capital that can provide for losses on these assets. In response, bank management can roll over the bad loans with the hope that the loan will eventually be paid back, or recognize the bad loans, take a hit to capital, and shrink the balance sheet.
Public sector banks have been doing a bit of both. There is little incentive for them to engage in asset substitution or excessive risk taking with the hope of increasing the chance of recovery and rebuilding capital as posited by Acharya. That phenomenon is more associated with rogue traders and bankers rather than top management of a public sector bank.
Acharya points out that state ownership distorts the incentives of bank management but importantly it also distorts the incentives of depositors and lenders in a way that affects the value of the equity of the bank. Government backing for state-owned banks essentially means that depositors and lenders to these banks believe that they are likely to be repaid even if the bank fails. We take government backing here to mean an implicit guarantee extending to all claims on a bank rather than the limited explicit guarantee provided by deposit insurance. As a consequence, depositors are willing to charge less interest to lend their money to the bank than if the bank’s failure was without doubt going to result in their having to assume some of those losses. This has substantial impact on bank profits and its ability to raise capital. Let us take an example to illustrate this. Suppose the bank is worth Rs100 and that Rs10 comes from owner’s equity and Rs90 from depositors/lenders to the bank. Suppose that equity holders considering the level of risk want a rate of return of 20% or Rs2 every accounting period.
Let the estimate of the chance of failure of the intermediary be 1% and this failure would ordinarily result in the bank reporting losses if there were no bailout. But given the government is solidly behind the bank, depositors anticipate they will get back their Rs90 if the bank fails and so they lower the interest rate they would charge for keeping their money with the bank by 1% as the 1% probability of failure will not be a damage to their assets with the bank. The cost of capital to the bank then reduces by 1% of Rs90 or Rs.0.9. This appears to be an insignificant sum till we put it in perspective, which is that it amounts to 45% of the Rs2 of return that equity holders want from the bank. Government backing provides a subsidy to equity holders and they would not have an incentive to lose that. If the bank is required to raise more equity in order to reduce its leverage, it would result in a loss of this subsidy.
For instance, if the equity holding were to go up from Rs10 to Rs20, then with the same chance of failure and required rate of return by equity holders, the subsidy reduces from 45% to 20%. In addition, once the bank becomes private and the government has no controlling interest then the government incentive to bail out the bank reduces, depositors would then require a higher interest for parting with their money to the bank, and the subsidy to the equity holders would be reduced further. Equity holders’ incentives to hold the shares of the bank would diminish.
Even if a potential holder of equity in the bank believes it can be put on a sounder operational foundation, she would hesitate from signing up for becoming a new owner. Bank managements in turn have an incentive to not bring in new equity that reduces the ownership stake of government in such a way that the backing associated with such ownership is diminished and the associated fillip to their operating profits. This is a Gordian knot that can be very difficult to break and will affect the possibility of restructuring a public sector bank with stressed assets.
While it is clear that restructuring a public sector bank that has too little capital will be beneficial for the economy, it turns out that it simultaneously decreases the private value of its equity, as the less it has government backing, the higher is such a bank’s cost of capital, and the advantage of the lower cost of capital is lost to the bank in the process of restructuring. The incentive of such banks is to avoid healthy regulation that would make them more capitalized and less toxic to the economy.
Similarly, mergers provide synergies in lending but this should be factored against the implicit funding subsidy that lowers funding costs and appears to make the bank more operationally cost- efficient than it really is. We must consider if the state is subsidizing equity holders or if equity holders are providing systemic benefits when called in to capitalize banks.
Errol D’Souza is professor of economics and dean (faculty) at the Indian Institute of Management, Ahmedabad.