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
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@example.com