Without Reforms, Bank Recapitalisation Will Amount to Throwing Good Money After Bad

The way the Banks Board Bureau has been allowed to function so far does not create much hope for reforms.

A cashier displays the new 2000 Indian rupee banknotes inside a bank in Jammu, November 15, 2016. Credit: Reuters/Mukesh Gupta/File photo

Former Reserve Bank of India (RBI) governor Raghuram Rajan recently admitted that the cleanup of bank balance sheets by acknowledging bad debts which started from December 2015 should have started much earlier. The problem of loan losses were initially “easy to ignore” , hoping they would go away “somehow”. But the scourge “had a tendency to increase, get too big to ignore, too late to manage, and push the system into crisis,” he had said.

Banks’ gross nonperforming assets (NPAs) rose in a single year from 8.42% of their assets in June 2016 to 10.21% in June 2017. Among the 20 banks with the highest gross NPAs, 18 are public sector banks. Rajan was prescient and now that the scourge is too big to ignore, the government has announced a massive recapitalisation of public sector banks by just over Rs 2 lakh crore or around $34 billion after their equity had been severely eroded.

This raises three questions. One, what happens to the fiscal deficit? Two, with the government pumping in so much money, what will it do to the rate of inflation? Three, will this booster dose of equity cure public sector banks of their ill health?

The first two questions are somewhat easy to answer. The fiscal deficit is a number which the entire financial sector, from multilateral agencies to private financial capital, lays great store by, somewhat akin to a physician’s constant watch over a patient’s blood pressure level. If there is a collective desire to look at this particular exercise as kosher, then the mere fact that the government’s own fiscal deficit target has been breached means nothing.

More important is our second question about whether the process will be inflationary or not. The whole exercise can be done through a set of book entries. The government puts fresh capital into banks which it owns. With this, banks acquire recapitalisation bonds issued by the government for the purpose, thus banks’ lend back to the government what they had received from it in the first place. This creates no additional purchasing power in the hands of anybody, not even the banks. They were in any case flush with funds – massively rising deposits post demonetisation. They were not lending for reasons other than shortage of funds.

With the fresh infusion of equity banks’ capital, adequacy will be restored and they will be able to lend again. As the debts of companies with large stalled infrastructure projects get resolved, they, likely under new owners, will get going again and the resultant spending will create demand and push up growth. It is only then that the issue of inflation may come up.

What happens to the basic cause of banks’ ill health? Credit: Reuters

Additionally, when banks earn interest on their recapitalisation bonds, it can add to their spending capacity. But this potential source of liquidity can also be sanitised. Thus, higher investment spending down the road in itself is unlikely to be inflationary; or corrective action can be taken as and when inflationary pressure is seen to be building up.

This brings us to the last and most important question: what happens to the basic cause of banks’ ill health? The answer is, restored capital adequacy is an enabler, not a cure. For banks to get out of the practices that led them into the quagmire of huge non-performing assets, they will have to change the way they function.

Also read: Explained: The Great Indian Bank Recapitalisation Push

Mindful of this, the NDA government created the Banks Board Bureau under the leadership of former comptroller and auditor general (CAG) Vinod Rai to act as a kind of buffer between the banks’ managements and the political dispensation of the day so that they could be insulated from political interference, thus improving their governance levels. The other role envisaged for the bureau was to select the right kind of senior management for the banks so that these competent professionals, insulated from the wrong kind of pressures, could run the banks professionally. This would engender sound lending, which would not subsequently result in loans going sour.

What has been the experience with the bureau so far? The depressing answer is ‘none too good’. Its scope of action has been narrowed (it is not to involve itself with the selection of chiefs of financial institutions), the government has changed appointments contrary to the bureau’s advice and even made appointments without consulting the bureau. The result is that political leaders and senior bureaucrats continue to call the shots. With little change in the ambiance in which bank managements function, there is no perceptible improvement in their governance.

One clue as to how government thinking has not changed for the better exists in some of the solutions that are being touted to set the future right for the banks. It is being said that from having around two dozen public sector banks, there should be half a dozen or so. Also, some weak banks should not be recapitalised.

The point is that there is no magic number like six or eight or ten. Besides, the decision to recapitalise or not should not depend on the degree of weakness. A bank may have become weak because of a particularly bad phase of leadership. What is critical is: can a bank have a future as an independent entity? This depends on its geography, nature of business, knowledge of local conditions and quality of staff down the line (not just top management).

A small bank with strong roots among the small and medium businesses in a particular area can be good for economic growth and job creation if only it has a competent top management. Such a bank should be administered the right medicine and allowed to remain independent and not be swallowed up in a huge administrative behemoth which will simply increase the time taken for information to travel up and decisions to come down. Put simply, big need not be strong or healthy.

Some commentators have described the recapitalisation as a bold new reforming move. This is not so in itself. Some good money has been put in but if it remains ‘business as usual’ then the recapitalisation will amount to throwing good money after bad. Then large NPAs will reappear after a few years as surely as night follows day.

Subir Roy is a senior journalist and the author of Made in India: A study of emerging competitiveness (Tata Mcgraw Hill, 2005) and the forthcoming Ujjivan: The microfinance frontrunner (OUP).

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