What would you do if your child is unhealthy? You will take him / her to a doctor. Medicines will be prescribed. Yet, child continues to remain unhealthy. Now, there will be complete body scan. Upon reports when doctors realise medicines are not enough, they would prescribe surgery. Yes, surgery.
Similarly, banks in India have been unhealthy for quite some time now. So what can government do? In 2008, after Global Financial Crisis banks in USA were bailed out by taxpayers money. However, in India the crisis is not so severe. Hence, government has resorted to Bank Recapitalisation through a transparent financial engineering process.
Need for Recapitalisation
As per the banking norms, for every loan a bank makes it needs to have 10% of it as capital. So if a bank wants to lend Rs. 10,000 to someone, it needs to have a capital of Rs. 1,000 with it. Now, if the loan defaults by even Rs. 200 then it directly affects the capital requirement. Capital reduces (1,000-200) to Rs. 800 as a result of such a default. As a result, for Rs. 9,800 worth of lending, bank now only has a capital base of Rs. 800 which is 8.15% of the capital. Doesn’t fit the capital adequacy requirement of 10%.
At this point, either the bank can call in the existing loan which isn’t possible so they stop lending more. This stops credit take off from it’s very source – banks. Hence, the need for recapitalisation.
Structure of Bank Recapitalisation
This adds upto a staggering Rs. 2.11 lakh crores. Indeed our public sectors banks are unhealthy.
Impacts on different stakeholders of Recapitalisation
Public Sector Banks
Banks which have already made appropriations for Non Performing Assets (NPA) will now be forced to recognise them as losses. Which in turn would result in erosion of capital. This erosion would be compensated by government by infusing capital by buying shares through bank recapitalisation process. Net effect, banks will be able to erase off their non performing loans while keeping their capital requirements intact. This would make banks healthier in process and would be able to make fresh loans.
Only caveat here is as banks will purchase these recapitalisation bonds, government will have to pay an interest on the same. This will add to fiscal deficit. Experts argue that interest amount of Rs. 10,800 crores a year considering 8% interest rate is won’t affect India’s fiscal health. However, every drop counts.
PSU Bank Shareholders
Shareholders of PSU banks will see a drop in book value of shares they hold.
Let’s look at this example. Mr. A invested Rs. 200 in a PSU bank. Issued capital of the bank is Rs. 10,000. Hence safe to say that Mr. A holds 2% in the bank. Now, government infuses Rs. 30,000 to recapitalise the bank. As a result, Issued capital of the bank becomes Rs. 40,000. However, Mr A continues to hold Rs. 100 worth of shares in the bank. As a part of restructuring, Mr A will now hold 0.8% of the shares of bank. Hence, shares held by PSU Bank shareholders will get diluted.
However, it’s important to note that price of the shares have not been reduced. On the contrary, after the announcement of this scheme, PSU Banking sector index has seen a rise of 33% till date. Which means, shareholders need not worry on this issue.
For depositors nothing changes. Apart from the fact that they can now place more confidence on solvency of the bank.
So if you had your fixed deposit in any public sector bank and were worried for a while. Then government will tell you to relax, the invisible hand is there to support you.
Some of our investors raised an important question pertaining to bank recapitalisation. Central theme of their question was ‘Why should we ‘taxpayers’ bail out immoral and wilful defaulters?’ This definitely is a very important question in this context.
However, it’s important to note that in last year’s budget Finance Minister had made an allocation of Rs. 18 thousand crores for banks from the government for which the provision has already been made. Even with this announcement, no fresh allocation of taxpayers money is allocated. As a result, there is nothing to worry for taxpayers.
Bank recapitalisation will help to accelerating structural reforms in Indian economy. Infrastructure reforms such as roads, railways, power etc., transport sector will also get immense benefit on the back of proper roads being built plus Goods and Services Tax has already brought down gestation period of tucks at inter-state toll booths, manufacturing companies will be able to not only provide for consumption in India’s economy adding exports will help to put India firmly on global map.
By fixing the credit supply in the system, bank recapitalisation will prove to be a win-win for all stakeholders.
Can consolidation of PSU Banks happen?
The constitution of Alternative Mechanism is a step ahead in their direction. In August, Union Cabinet had decided to consolidate existing PSU banks under this mechanism to create stronger banks. Committee for Alternative Mechanism will be headed by Finance Minister Arun Jaitely.
One question that always strikes our heart is ‘How did situation become so bad in the first place?’ We were such a strong economy on the path to become a superpower but all fell apart.
What happened in the context of Public Sector Banks?
Flashback 2014, then Reserve Bank of India Governor Raghuram Rajan, brought to light the unhealthy state of banks. He pushed for an asset quality review. Till that time, most of us thought ‘all is well’ and then looking at bad assets amassed we were informed that ‘all is really not well’. The numbers of ‘Non Performing Assets (NPA) ’ (loans given by bank which cannot be recovered) we saw were spectacularly high.
Due to this, banks were not only able to lend more money which is it’s primary source of income but even staying solvent was becoming a challenge. If money is stuck in the system and doesn’t come back to banks, then overall economic growth takes a backseat.
Why did this happen?
FY 2008-2013 was an era of stalled projects, immeasurable scams (2G scam, CWG scam, coal scam) and needless delays in executing projects which resulted into a standstill. Yet, the world was changing. Economic environment had become far more dynamic for India to be standstill. In other words, India did miss out.
So how is it connected to banks?
Companies take loans from banks to execute projects. If these projects get stalled for no reason (Tata Nano, Singur) or Government doesn’t allocate projects (2G spectrum scam) or there are unnecessary delays in obtaining licences to execute project (unease of doing business) then money gets locked. Also, this gives rise to morally incompetent people who float companies just to obtain loan and run away somewhere far in London, England while having their favourite drink. The whole eco system starts to breed unethical, fraudulent and immoral behaviour.
Banks which have lent money has a hard time to recover those loans. Safe to say, unhealthy. As a result, banks cannot make fresh loans to deserving projects or those projects that need of the hour. As there is lack of credit in the system, entrepreneurs are discouraged to take up more projects. As a result, no improvement takes place. Infrastructure and transport remain the same, worse off on a global scale a country tends to regress. Confidence in the system is lost.
This gives rise to a vicious circle.
In such a scenario, banks first need to recognise assets that have gone bad. Which determines the extent of fresh money required by them to start the process again. Now, banks start to look at government (one and only saviour). But, government makes money out of tax collections from citizens. Infusing honest tax payers money to cover incompetent businessmen’s bad loans brings about a negative mood to honest tax payers, especially salaried class.
This has given birth to a new challenge for the government.
If they borrow money from outside, fiscal deficit (revenue less expenses) widens as they have to pay back compulsorily regardless of bank being stable or not. If they use taxpayers money, sentiments are hurt and their chances of being re-elected become grim. So what to do?
Because of unhealthy lending structures, Public Sector Banks have suffered a lot more than Private Sector Banks. Hence, this recapitalisation is for Public Sector Banks only.
Dear readers, if you have any further query on Recapitalisation please feel free to write in the comment section below and we will resolve the same.
– Jinay Savla