Bank recapitalisation is a must

Topics bad bank | Bad loans | Lockdown

As the exit from the lockdown unfolds — interrupted in many places by the re-imposition of short lockdowns — many speak hopefully of green shoots springing up. Others talk of a V-shaped or U-shaped recovery. 

We need to be clear about what “recovery” means. When people talk of a recovery, they mean the reversal of the shrinkage in output that is happening at the moment. If output drops by 5 per cent for the year as a whole after dropping by, say, 20 per cent in the first quarter, that points to a recovery in the next three quarters.

Any sign that things are getting better is welcome. But we must not lose sight of the correct economic objective. Before Covid-19 struck, India’s economic growth was projected at 6 to 6.5 per cent in FY 2020-21. In 2021-22, the economy was expected to grow at upwards of 7 per cent, thus getting back to the long-term growth path. The correct economic objective is getting to that point. 

We also need to be clear as to what is needed to get there. Of the factors responsible for the deceleration in growth for eight successive quarters up to March 2020, one stands out. It is the twin balance sheet problem, that is, high leverage in the corporate sector and a high level of non-performing assets (NPAs) in banks. 

The twin balance sheet problem is poised to get a lot worse consequent to the pandemic. Analysts expect non-performing assets to rise by around five percentage points in FY 2020-21. Corporate balance sheets too will worsen in many sectors.  The level of output we had hoped to reach in 2021-22 will now be attainable, perhaps, only a further two years down the road. 
Even that cannot be taken for granted. We need to resolve the crisis in the banking sector. For this to happen, two requirements are paramount. One, recapitalisation of the banking system and, two, resolution of bad loans. 

Several private banks are way above the minimum regulatory requirement of 10.875 per cent of risk-weighted assets. Yet, they have announced plans for raising large amounts of capital. Why? Because they believe a rise in NPAs will erode capital. And, also, because they see merit in having a cushion of 4 or 5 percentage points above the minimum capital requirement. 

Such a cushion creates confidence in investors about the stability of the bank. Moreover, when a bank operates with a small cushion, a few bad loan decisions could cause capital to fall below the minimum. Management lacks the courage to pursue loan growth or take risky exposures. 

Public sector banks (PSBs) don’t need as large a cushion as private banks because investors know the government stands behind them. Still, they can’t afford to operate at the regulatory minimum. PSBs had a capital adequacy ratio of 13 per cent in March 2020. The minimum capital requirement is poised to go up to 11.50 per cent in September 2020. The cushion of 1.5 percentage points that PSBs have will be eaten away by the rise in NPAs this year. 

Analysts estimate that PSBs would need at least Rs 50,000 crore in FY 2020-21 for meeting the regulatory minimum. If we provide for a margin of 2 percentage points above the minimum, the requirement would be substantially higher. Yet, the two rounds of stimulus packages announced by the government made no mention of any provision for recapitalisation of PSBs. 

It’s not helpful to say the government doesn’t have the funds to recapitalise banks. If the level of public debt is an issue, let the government monetise the deficit instead of going in for borrowings. Many see monetisation of deficit as a no-no because they fear the impact on money supply and inflation. 

They overlook the fact that the Reserve Bank of India (RBI) has hugely stepped up buying of government securities in the secondary market. The impact on money supply is the same whether the RBI buys government securities in the secondary market or in the primary market (which is monetisation of the deficit). It’s time to break the taboo. 

Loan resolution is also crucial. The  Insolvency and Bankruptcy Code process has been suspended for a year. How are banks to deal with defaults in that period? There is no escape from restructuring of loans. Restructuring often means waiving a portion of the loans. PSB managers don’t want to restructure loans because they fear, rightly, that it means having to answer to investigative agencies. 

The Indian Banks’ Association has revived the idea of a bad bank or an asset reconstruction company that will take over stressed assets. But asset reconstruction companies in India have a poor record of reviving companies. They tend mostly to sell assets. That is not what the economy needs. We want to preserve assets and keep them productive. 

Banks are well placed to do the job. But for bankers to be motivated to undertake it, they need assurance that they will not be hounded. A statutory authority that will set up multiple panels to vet high value loan restructuring could be the answer. 

It’s bad enough that the government has not acted to recapitalise banks and empower bank management. On top of that, there is incessant talk of privatising the weaker PSBs. Privatisation or even a fall in government ownership below 50 per cent will require an amendment to the Bank Nationalisation Act. That would be a contentious and long drawn-out affair. 

In the interim, bank lending would be the casualty. For now, the government must focus on reform within the framework of government ownership. It must inject capital and strengthen management and governance at PSBs. All else is a costly distraction. 

The writer is a professor at IIM Ahmedabad.

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