On 24 October, finance minister Arun Jaitley unveiled a slew of measures to mitigate what the Economic Survey called the “Twin Balance Sheet (TBS) crisis with Indian characteristics". The cornerstone of suggested measures is a Rs2.11 trillion package for the beleaguered banking sector. Chief economic advisor Arvind Subramanian called this package Brahmastra—the most effective weapon in the Hindu mythology.

What are the main components of the package?

This package has two components. It envisages a Rs76,000 crore outlay out of existing resources. Out of the present budgetary allocation for bank recapitalization this fiscal year, Rs18,000 crore will be “released". Further, banks will have to raise the remaining Rs58,000 crore from the stock market. As “Indradhanush" (the existing recapitalization programme) includes both these elements, this component is a reiteration of existing measures. 

What is new is the proposed bond scheme worth Rs1.35 trillion. This scheme will work in two legs. In the first leg, the government will issue securities to banks. In the second leg, cash received from the sale of securities will be ploughed back. 

Typically, cash infusion takes two forms. In the first form, the government purchases bank equity, preference shares or similar instruments. Effectively, the government is buying a slice of the entire loan portfolio. This mechanism was tried in India in the early 1990s. The second option involves buying stressed assets from the banks and taking them off the banks’ balance sheet. The US’ Troubled Assets Relief Program (TARP) used both these mechanisms. 

Arvind Subramanian has recently argued in favour of buying stressed assets for two reasons. First, cleaner balance sheets will encourage private capital investment in banks; second, taking troubled assets off the balance sheet will free bank management to pursue business without being distracted by the management of bad assets.

What are the benefits of the scheme?

The package will ensure that the banks are able to absorb losses arising out of bankruptcy procedures and write downs, without compromising their capital adequacy and other regularly ratios. Further, in the absence of regulatory forbearance, banks must prepare for the eventual roll-out of the Basel-III based prudential norms which require separate capital charges for market, credit and operational risks, respectively. Both require substantial capital infusion.

As the central government is legally required to hold not less than 51% of the paid-up capital of nationalized banks, a fully market-led bank recapitalization programme can be ruled out. In a sense, bonds are the only option left on the table.

What are the various design features and their respective pros and cons?

A successful bank recapitalization programme must balance many delicate considerations. It should make systemically critical banks profitable and reduce their liquidity, duration and interest risks. At the same time, the recapitalization programme should keep fiscal cost low. It should not crowd out private investment and spike yield rates. Naturally, it must be consistent with the legal requirements.

The first interesting question is whether the securities will be issued by the government or some Special Purpose Vehicle (SPV) guaranteed by it. This will have implications for the computation of the headline fiscal deficit number. The Fiscal Responsibility and Budgetary Management Act (FRBM, together with associated rules) imposes a limit on the fiscal deficit-to-GDP ratio. Fiscal deficit is defined as any borrowing that flows into the consolidated fund of India. 

In some cases, the government has circumvented these provisions by borrowing through special securities, essentially treating them under a sovereign guarantee framework. However, FRBM also imposes a ceiling of 0.5% of the GDP for assuming incremental guarantees in a financial year. It will be interesting to watch how these limits are circumvented. One possibility is that FRBM rules may be amended.

Second, there must be balance between parliamentary accountability and autonomy of the capital infusion process. As long as public funds are being utilized, there will be public scrutiny. But a close involvement of the finance ministry will politicize the process, which is bound to be controversial. 

The third issue is whether securities will be tradable and counted towards SLR requirement. If these are included in SLR requirement and there is no restriction on their transferability, they will compete with new issues of G Sec paper and drive up yields. Downside of restriction on tradability is that it makes the instrument illiquid. If the bank holding such securities is liquidity-constrained, it will find it difficult to operate even after recapitalization.

Fourth, what will be the maturity profile of a bond issue? A longer dated bond will be deemed risky; it will have a larger coupon payment. Moreover, it will be less liquid. Conversely, short-term bonds will have to be redeemed sooner and they will sharply increase fiscal deficit in the year of redemption.

Fifth, there will be a trade-off between bank profitability and fiscal cost due to interest payment. If coupon payment is set below market price, it will reduce the profitability of the bank. If it is issued at market price, then the exchequer must bear the loss.

Ultimately, there is unlikely to be a homogeneous issue. Most likely, these bonds will be packaged into multiple chunks of varying characteristics to meet multiple objectives. Further, there will be restructuring along the way. Recap bonds issued in the 1990s were structured twice.

Is the recapitalization package really costless?

This is a tricky question. One way to answer this question is to look at the earlier experience. Between 1994 and 1998, bonds officially titled “10 percent GOI Nationalised Bank Special Securities 2006", worth Rs20,446 crore, were issued to 19 PSU banks. In 2002, these recapitalization bonds were restructured into perpetuities (securities that pay a fixed sum forever). Again in 2007, these perpetuities were restructured into marketable securities of 15, 20 and 25 years’ tenure.

Budget documents reveal that the special securities issued to nationalized banks (converted into marketable securities; total value Rs20,808 crore) are still outstanding. Annual interest outlay on these securities is approximately Rs1712 crore; these securities will be redeemed (paid back) at face value in 2022, 2027 and 2032, respectively. Bonds amortize the cost of recapitalization over a very long period. Still, they are not costless; there is no free lunch.

But wait a minute. There is a crucial difference between bailouts in the 1990s and the present case. Previous bank losses were a result of priority sector lending; essentially, they had to be written off. Current stressed assets are concentrated in the corporate sector. The government is actually buying these assets on distress prices. Some of these assets will be duds. But some of these companies are suffering from a temporary liquidity crunch; their current prices are lower than long term value. They may turn out to be jackpots. Historically, bailout packages such as the one involving the hedge fund Long-Term Capital Management (LTCM) have actually made money.

That said, there is still a huge lemons problem. Banks and market participants know their asset portfolios much better than government officials; they would like to offload junk assets, while retaining good assets. This informational asymmetry is one reason for preferring bank recapitalization (in which the government essentially buys the average loan pool) over buying stressed assets.

Will it revive investment, growth and employment immediately?

In the short run, corporate investment in India is constrained by multiple factors. These include lower demand, high cost of raw materials, uncertainty due to the GST transition and ongoing bankruptcy procedures. It is unlikely that bank recapitalization alone will solve these problems and revive capital expenditure cycle, at least in the short run. 

Having said that, banks remain the heart of the financial system in India and their capitalization is critical for savings mobilization, credit offtake and revival of investment demand over the medium term. 

An end to crony capitalism?

The only costless way to manage the NPA crisis is to grow out of it. Given the long-term growth potential, the Indian economy will ultimately survive the NPA crisis. But the recurrence of NPA crises within two decades shows that banking sector policies require a major overhaul. 

The NPA crisis is ultimately a reflection of skewed incentives, in particular moral hazard. Banking sector reforms following recapitalization are perhaps as important as the specifics of the bail-out programme.

Avinash M. Tripathi is an independent contributor on economic issues.

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