Recapitalisation of Banks

The Government of India recently announced recapitalisation for the banks going under bad loan problem. Finance Minister, Arun Jaitley has stated that Rs. 2.11 lakh cores shall be infused in those banks which are facing the problem of bad loan for over a period of two years. This step is being seen by the economists as a boost the morale of public sector banks financially after demonetisation.

What is recapitalisation?

The simple meaning of the term ‘recapitalisation’ for banks is recapitalising or putting new capital to improve the balance sheet of the bank. Those banks which are undergoing the problem of bad loans / credit crunch are helped by the government (being the stakeholder in the bank) by infusion of capital through different instruments.

When the liabilities of the banks exceed their assets, the credit ratio increases which leaves the banks with less capital and more loans. Hence, the government invest money to decrease the gap between money lent and capital of the bank. This leads to better capital credit ratios for which banks can now raise more capital. Credit increases. Some more scope for losses also exists. Effectively, what the government wants to do is force banks to take losses by pushing NPAs to real losses, as the government replenishes the capital that is lost.

What was the need of recapitalisation?

For long period of time Indian banks have been facing a sluggish bank crisis, particularly the state-controlled institutions that dominate the sector have a bad-loan ratio that’s almost twice as bad as their private counterparts. The non-performing assets made up more than 10 percent of banks’ advances, are growing at faster rate. Naturally, banks faced with this burden aren’t exactly eager to lend, so credit growth to the private sector has hit historic, multi-decade lows. Therefore this led to the government which is the stake holder of the Public Sector banks to financially engineer the situation.

What are the means of recapitalisation?

The Government is focussing to maintain its fiscal deficit to 3.2% and hence cannot give money to the banks for the treasury. Therefore, the government announced recapitalisation through two different methods. The infusion of Rupees 2.11 lakh crores or 32 billion dollars shall be done by:

• 1.35 trillion shall be paid out through recapitalisation bonds; and
• 76,000 Crores shall be paid out through budgetary support from the markets.

What are recapitalisation bonds and how do they work?

A bond issued for the purpose of recapitalisation is called recapitalisation bonds. It is a government bond to raise money from the market with a promise to pay to repay the face value of the maturity date and a periodic interest.

Recap bonds will be issued by the government which the banks will subscribe to and it will be entered as an investment in their balance sheet. The banks will then lend money to the government for subscription of the bonds which will go back to banks as capital. This will immediately strengthen the balance-sheet of the banks and show capital-adequacy. The money lent to the government for subscribing recap bonds is free from becoming a bad loan as the government is always solvent.

What will be the impact or potential outcome of recapitalisation?

The fiscal deficit will not be immediately affected as the government is not infusing money from the state coffers, but it also depends on how it is being accounted in the books of the government. Since it is a long-term debt, it provides time to banks to improve their balance-sheets by increasing their credit and private investment. The government, then, can retire the debt from the proceeds by selling the bank equities purchased earlier, once banks’ situation gets better. The government’s plan will have little impact on its target to shrink the shortfall to 3.2% of GDP in the year through March 2018 because the IMF’s rules classify such debt as “below-the-line” financing. Only interest expense will be added to the fiscal deficit, and this is estimated at about Rs90 billion each year or 0.4% of total budgeted spending. Technically, however, India’s accounting rules require the bonds to be included in the budget deficit, so the government will probably reclassify them later as off-balance sheet items—just as it did when similar notes were issued in the 1990s.

Critical analysis of recapitalisation

The recapitalisation has a negative side to it as well. First of all, it may set a bad precedent as it send out a wrong message to both the lenders and the borrowers that the government will come to the rescue of the PSBs even if they lend indiscriminately without exercising due diligence and PSBs are not likely to mend their errant ways.

Secondly, recapitalisation is a temporary and not a permanent solution. The issue of Non-Performing assets shall persist despite the recap. The solution to the NPA issue is to ensure that the PSB boards maintain highest standards of corporate governance and financial accountability. The government needs to enforce such discipline by making the boards fully accountable for their actions and liable for their errors, omissions and commissions. Only then will PSBs become strong enough to compete with private sector banks.

Exam Topics Suggestion

Prelims

Key issues around banks in India in recent years have been Bad Debts or NPAs. Basic idea on what is NPA, How they are classified is needed from our economy modules.

Mains

This is an ongoing event and we need to keep a check on how recapitalization actually helps the banks. Its impacts on public finance, particularly fiscal deficit is to be observed.