MUMBAI : A clear majority second term for the ruling party-led government has emboldened investors to expect a push for banking reforms. The Nifty PSU Bank index has galloped over 13% since the exit poll results were announced, while the index made up of private banks hasn’t matched this run, with returns of less than 6%.

After all, the economy needs credit to grow and does not have the fallback option of borrowing from non-bank lenders. To lend, public sector banks (PSBs) need capital and Icra Ltd estimates this could be at least 30,000 crore in FY20. “If banks are not able to raise their required capital, to that extent the obligation would fall on the government," said Anil Gupta, vice-president and sector head for financial sector ratings at Icra.

Getting this money will not be easy as the government’s coffers are in the grip of its own promise of prudence.

Since desperate times call for desperate measures, the government could dip into the Reserve Bank of India’s (RBI) capital. “With the Modi government getting a renewed popular mandate, it should be easier for the Jalan committee to hand over the excess RBI capital in one shot to the MoF (ministry of finance)," Bank of America Merrill Lynch said in a note.

But it is one thing to give money and another to make it work. We only need to look a short way down history to know that most of the capital given by the government to state-owned banks has gone down a sinkhole.

The government’s mammoth bank recapitalization plan in October 2017 aimed to make a splash. But lenders could only manage to keep their noses out of water. Lenders are going under again, with the second wave of stress triggered by Infrastructure Leasing and Financial Services Ltd. The FY19 results of 17 public sector lenders show that they had to provide an aggregate of 1.99 trillion towards dud loans, and in doing so, raked up a net loss of roughly 47,000 crore for the year.

The capital worth 1.05 trillion that their owner gave during the year disappeared without a trace.

To be fair, some banks that were under a lending quarantine by the regulator got independence to lend like they used to before. The objective of the infusion was to just make sure lenders live another day by meeting regulatory minimum on capital. The aim was never to give them growth capital. Even so, investors should be mindful of this experience before getting excited about the prospects of these banks.

The other solution is, of course, forced marriages. Analysts such as those at Prabhudas Lilladher said mergers could not be escaped. “The government’s budget allocation has negligible capital infusion plans, and the capital requirement for smaller banks still remains much higher and raising from market will be not conducive; hence merger will be the only option," the brokerage said in a note.

But mergers have their challenges. Recall the combination of State Bank of India (SBI) and its associates that led to a sharp escalation of SBI’s bad loan stock and a collapse of its loan growth for a quarter because its employees were too busy with the merger to go out and lend.

The full implications of the three-way merger between Bank of Baroda, Vijaya Bank and Dena Bank are yet to emerge. It is feared the picture won’t be pretty.

Moreover, mergers have been just rescue missions and hardly boost credit for the system. “Together or apart, the loan growth of the banking system as a whole doesn’t change after a merger," said Rakesh Kumar, an analyst at Elara Capital.

The third solution of privatization, analysts say, is politically unpalatable and the government wouldn’t want to pursue it.

Privatizing banks may involve job losses, not to mention the fact that the government’s social schemes cannot be carried out with ease. However, privatization would be among the most viable solutions with long-term gains. In comparison, recaps and mergers will look like patchwork, with mending needed every now and then.

Indeed, there are no easy solutions for the mess PSBs are in. As far as return on assets or even return on equity is concerned, banks were unlikely to show improvement in FY20, said Kumar.

Therefore, investors need to price in the headwinds before they become bullish about the future of public sector banks.

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