Three Myths about Recapitalisation of Public Sector Banks

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The ‘sin’ of public sector banks is that they lent heavily to infrastructure projects that never took off. The way forward is to provide for loan losses, infuse capital, fix their management and governance – and look to revive lending

Bank branch, Madurai. Credit: Patrik M. Loeff, CC 2.0

Bank branch, Madurai. Credit: Patrik M. Loeff, CC 2.0

The NDA government has made, perhaps, its first decisive move on the economy. Last week, the government announced a plan to infuse Rs 70,000 crore into public sector banks (PSBs) over the next four years. This one move, more than the plethora of ‘reform’ announcements we have had over the past year, promises to give a much-needed boost to growth and investment in the immediate future.

And yet it has been long in coming because the government bought into the myths that beset the issue of bank recapitalisation in India. It’s worth examining these myths if only because many of these are taken as self-evident truths in the discourse on economic policy.

Myth no 1: Capital infusion by government into PSBs represents a ‘bailout’ of these banks by the exchequer.

A ‘bailout’ happens when a bank has failed. In regulatory terms, this means the bank’s capital adequacy – the ratio of capital to risk-weighted assets – falls below the regulatory norm. This norm is 8% as per the Basel standards. The RBI prefers to keep the norm one per cent above the Basel standards, that is, at 9%. Not a single PSB had capital adequacy below 9% in March, 2014 (the last date for which RBI website provides bank-wise figures). Indeed, except for four PSBs, all meet the higher capital adequacy requirement of 10.5% which Indian banks are expected to meet only in 2019.

If PSBs meet the capital adequacy requirement stipulated by the regulator, why do they need more capital? Well, that’s because banks cannot operate strictly at the minimum capital level stipulated by the regulator. If they were to do so, then even if a few loans go bad, they could fall below the capital requirement and won’t be able to continue lending.

Typically, banks find it prudent to operate at a capital level of around 5 percentage points above the minimum capital requirement. This gives them the freedom to take risks in lending. This would mean that banks would need a capital adequacy ratio of 14%. Some of this capital can come from the market but the government would also have to chip in if it is to retain majority ownership, which is the stated policy today.

Myth no. 2: Repeated infusion of capital by the government is ‘money down the drain’.

If a bank is highly profitable, it can manage enough capital from retained earnings and from the market. The government would not have to chip in. So repeated capital infusion by the government, critics say, is money down the drain. They ask: why should the government support the banks with taxpayer funds from time to time?

The question might as well be asked of governments all over the world. From time to time, economies suffer banking crises and governments have to infuse capital into privately owned banks. There have been nearly 100 episodes of banking crises in almost as many economies in the world since 1971. Governments spent an estimated 13% of GDP on the average to clean up their financial systems. In many economies, the cost has been upwards of 50% of GDP.

These fiscal costs are not the most accurate measure of the damage done to economies. The real damage is the loss to output that arises from a banking crisis. In 2011, the report of UK’s Vickers Commission estimated the median loss of output in a banking crisis at 63%. The Commission interpreted this to mean that an annual cost of 3% of GDP was worth incurring to prevent a 5% chance of a crisis that would mean a loss of output of 60%.

In other words, given the way banking systems are structured today, they are bound to impose fiscal costs. We can choose to incur the cost after a crisis – as has happened in economies around the world. Or, we can choose to incur a cost in order to prevent a crisis – as we have done successfully in India thus far. And here’s the punchline: the costs of recapitalisation incurred in India are, perhaps, the lowest in the world. In the 1990s, the cost incurred was around less than 2% of GDP. The costs in the 2000s would be around 1% of GDP.

This expenditure has not been money down the drain. Following the recapitalisation that happened in the 1990s, the value of government shareholding in PSBs appreciated through the 2000s. (To take the best case, State Bank of India, the value of a share issued at Rs 90 in the early 1990s is today Rs 2700). Unfortunately, we do not have a mechanism whereby the government can actively manage its portfolio of PSBs, selling off small portions of shares when prices are rising and realising gains that can then be ploughed back as capital infusion whenever required. If such a mechanism had been present, the government would not have had to use budgetary resources to recapitalise banks.

Bank recapitalisation would be money down the drain only if the performance of PSBs showed a declining trend over a long period of time. This is emphatically not the case. From 1993-94, when banking reforms commenced, there was an improving trend right up to 2011. Only thereafter has performance taken a beating, thanks to PSBs’ heavy exposure to infrastructure – which has been impacted by regulatory and other failures.

Myth no 3: Given our fiscal situation, government does not have the resources for bank recapitalisation

Newspaper headlines talk of a capital requirement of Rs 500,000 crore for PSBs over the next five years. This seems a daunting, or even impossible, task – until you grasp the fact that this is not the amount the government has to put it in.

The five year estimate (which itself rests on assumptions of weak profit growth in PSBs) translates into an annual requirement of Rs 100,000 crore. Of this, the equity requirement is roughly half, or Rs 50,000 crore. The remaining half can be raised by way of bonds. Of the requirement of equity, the government has to put in roughly half – or Rs 25,000 crore. This is not a small requirement but certainly not unmanageable.

In its first year in office, the government took the position that it would hand out capital to PSBs based on their performance. Only banks that were doing well would get capital; banks that were not doing well must fend for themselves and improve performance first before they qualify for capital. Following this approach, the government promised Rs 11,200 crore in the budget for 2014-15 and ended up infusing Rs 6990 crore. In the budget for 2015-16, it provided a sum of Rs 7940 crore. These amounts are woefully short of the annual requirement of around Rs 25,000 crore.

This is not the approach to take if we want banks and the economy to revive. Banks cannot raise capital from the market unless they improve their performance. Without capital from the government, banks cannot lend and hence they cannot improve their performance. And without an increase in lending, the economy cannot revive. Punishing banks for past sins is no way to revive the economy. That is why governments everywhere respond to a banking crisis by resolutely recapitalising banks.

In India, it is not even clear that, on the whole, PSBs have sinned. Their sin, if any, is that they funded private investment in infrastructure that underlay the India Shining period of 2004-08. Following the woes in infrastructure (and sectors such as mining and construction), banks have been saddled with large non-performing assets (NPAs). As a result, they are in no position to finance fresh investment. The way forward is to provide for loan losses, infuse capital, fix management and governance at PSBs – and look to revive lending. It is to the credit of the government that it has recognised its error and changed course.

T T Ram Mohan is a professor at IIM, Ahmedabad. Email: [email protected]

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    (1) Many a reader would agree with what the
    author of this article says. In the present circumstances when financial health
    of our Public Sector Banks (PSBs) is unsatisfactory, the Central government
    does not have any option but to invest funds in these banks. But question is
    this would that be good enough? Author has answer to this question. (2) Low
    productivity/business per employee, ever-growing and high non-performing assets
    and poor customer service are some problems which require immediate attention
    in these banks. Solutions for these problems are of course not easy, in view of
    bank employees’ opposition to reforms and the government’s inability to take
    tough decisions. (3) Let us also not overlook the bitter truth: our PSBs have
    fared poorly basically because of political and bureaucratic interference in
    their management. Orders from Delhi to bank chiefs are not unusual. (4) Hence,
    if we want our PSBs to do well, the government should implement reforms,
    appoint professionals on Boards of these banks, have in place governance norms
    for these banks and give more autonomy to Boards with accountability standards
    in place.

  • desii desii

    The state of PSU Banks is like UTI64 … the govts abused their responsibility by advising the fund managers when and what to buy and sell (an Fm was called minister of Reliance by a daily at one point of time), and then the fund managers abused their responsibility as front running was rampant ,,,
    Insiders knew that UTI64 nav was below par and in the end everyone was making money on the side and the small investor was left holding the bag.

    The rot is always at the top and until the netas and babus in power stop using govt companies as personal property and private fiefs instead of running them as treasurers of public wealth,,, the situation wont change and recapitalization will be a routine affair and burden on taxpayer and the small lower middle class hardworking person who will pay for it in infaltion tax !

    Lets take this article
    India Shining period of 2004-08 can the professor go into more detail on this ,,, things worsened after 2008 did they not ?

    1. The banks may not have failed but he admits willy nilly…. that they are diseased and unable to run healthily ! and some banks are on respirator as ther is clear case of incompetence/ corruption / misconduct of top management…
    eg United Bank / Punjab and Sind bank / Syndicate Bank where small investors have lost 70% of the capital invested during Congress upa time IPOs.
    Was there no mismanagement ? did the banks not mishandle handle post 2008 money printing and monetary expansion boom properly ?
    read/ google Lucrative’ assignments: A Messy Saga

    I have heard an accountant working for a rather famous industrialist marwari family of how a very easy settlement that favored the industrialist was accepted by an imperial bank once cash settlement was achieved with some PSU bank bosses and a stay on his property was removed to allow property to come up in place of a defunct mill!

    2. Two wrongs dont make a right , Why is the professor comparing the western economy s where politics is funded by superpacs and currency is free float with a crony capitalist mixed economy such as India .
    As things stand financial crises happen mainly because of big money in politics and crony capitalism and politics and politicians who doesn’t allow healthy corrections in the economy and try helicopter tactics when there is a bust . Just so that big bosses dont take bonus and salary cuts and people are happy and politicians get voted in !

    Sadly we have done rather worse than the west in bettering peoples lives while our currency has had a rather precipitous fall in terms of the dollar! Have the Indian banks not operated on much higher margins or spreads than the west ?

    3. Has the kind professor accounted for monetary inflation or govt policy induced booms while talking of increase in share prices of sbi or psu performance … and has he compared the performance of a psu bunch and and say a private bank bunch over the long term to make it more beleivable ?

    Im reminded of the great Milton Friedman statement “inflation is always and everywhere a monetary phenomenon.” Monetarism is an economic theory that focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability.
    and Why just the Shining period from 2004 to 08 ? and not after that ? The rot worsened ….

    This reminds me of Mark Faber as he says that “I’m most gloomy about the prospects of the global economy, but it doesn’t mean that markets will go down,” Faber said, thanks to “mad professors at central banks” who could implement another round of quantitative easing in the near future.

    4. I agree it is a hobsons choice and a conundrum ..

    But will the govt take tough unpopular decisions to change the work culture in PSU banks as staff is highly unionized and doesn’t want to work ! Either their vigilance depts suck and cannot really catch fraud or the bosses dont want the NPAs to come out in the open …Vijay Malya still partys doesnt he?

    Will the govt follow the Singapore Temasek Holdings model and disassociate itself from the running of PSUs ? Will the govt stop interference and will it make PSU Bosses more accountable to people and more profit oriented and the governments more accountable.

    Should the govt not run PSU banks profitably and use the profits for defined public good ?Instead the govts have milked PSUs in general in the name of service motive while their cronys profiteering from such policy while the common man got a babaji ka thullu ??