A red light and green arrow are displayed on a light-emitting diode (LED) traffic signal. (Photographer: Akio Kon/Bloomberg)

The Mega Bank Recap: The Best Of Bad Options

There have been two schools of thought on the Indian banking sector.

One which suggests that we have spent too many years and too much money supporting inefficient public sector banks. These lenders should now be left to fend for themselves. In the process, if they get weaker, so be it. Private banks and the corporate bond market can fund capital needs of the economy and, in turn, improve credit discipline.

You can’t do that, says the opposing camp.

The Indian economy needs its public sector banks. There are still a number of economic objectives that may need the support of government-run banks. Besides, these banks still account for nearly 70 percent of the banking sector, although their share in incremental lending has fallen dramatically in the last two years. Supporters of this view argue that private banks and bond markets fund only a handful of firms.

For a while it looked like the government had bought into the first argument. Despite calls from the Reserve Bank of India, rating agencies and banks themselves, the government held on to a 2015 recapitalisation plan which involved infusing just Rs 70,000 crore in these banks over a four-year period. A fraction of the capital needed. Over time, the calls turned into appeals. Some almost emotional.

“...every few days, I wake up with a sense of restlessness that time is running out,” said RBI deputy governor Viral Acharya in a September speech, while adding that there is an urgent need to restore the Indian banking sector to health. This, as Acharya and others have argued, is essential to ensure that the Indian economy can move beyond the twin-balance sheet problem (of weak corporate and bank balance sheets) that has plagued it for some time now.

On Tuesday, the government yielded. Convinced, if not by the proponents of bank recapitalisation, then by the need to show that it is doing enough to keep the Indian economy on a high growth path.

Revising its recapitalisation plan, the government said that it would infuse Rs 2.11 lakh crore in state-owned banks over two years. Rs 1.35 lakh crore of this would come in the form of recapitalisation bonds. The rest would come from the budget.

Many questions arise. Is this a bailout of inefficient banks? Will this hurt government finances? And are recapitalisation bonds a form of financial jugglery? Are we throwing good money after bad?

The answers are not binary.

Let’s start with the first question. Is this a bailout? Yes, of sorts. After all, in an ideal world, banks should raise their own capital. But remember that these are government-owned banks. So if they are in need of capital, the primary shareholder has a responsibility to pitch in and raise that capital. Also remember, that the government (so far) does not appear willing to privatise and lose control over the functioning of these banks. If that is the case, then it is only fair that the government shares the burden of recapitalisation. So while some may call this a bailout, it should be seen a bailout by the promoter, which, in this case, happens to be the government.

Questions will also be raised in the coming days about the mode of recapitalisation and the eventual impact on government finances.

Using bonds to recapitalise banks is essentially a little bit of financial jugglery. The government issues bonds to banks, who subscribe to them and hold them on their investment books. The money the government raises goes back to the banks in the form of equity. This prevents a large cash outgo from the government’s coffers immediately but solves the problem of banks showing low levels of capital adequacy. Former RBI governor Y.V. Reddy explained it best in an interview with BloombergQuint in July.

The injection of capital is essentially to meet the regulatory requirement and convince everyone that I am also behaving like any other owner. That is why I say there is no threat to the solvency of the system. Therefore, the injection of capital is only to meet the technical requirement of the regulator,” Reddy said.

So while, there is some bit of financial jugglery involved, recapitalisation through bonds will prevent an immediate burden on government finances while allowing banks to look and feel healthier.

According to Finance Minister Arun Jaitley, the recapitalisation bonds won’t be counted towards the fiscal deficit. Even so, most rating agencies will take note of the increased liabilities on the government’s books. They may, however, acknowledge that a sizeable bank recapitalisation plan was urgently needed and balance their criticism on weaker government finances. A senior former RBI official said, on the condition of anonymity, that whether these bonds are counted towards the fiscal deficit depends on whether they are issued by the government or an agency of the government.

The final question is the most crucial. It also has the most obvious answer. And the one over which the government has most control.

The judgement on whether we are throwing good money after bad will depend on what the government does next. Recapitalisation must be accompanied by reform.

What these reforms are is well documented. But the most critical of them, as former RBI governor Bimal Jalan told BloombergQuint, is to ensure these banks are first given autonomy and then held accountable for their performance. At a ‘gyan sangam’ in 2015, the government promised that banks would be given greater operational freedom. Has the government stuck to this promise? If the push for MUDRA loans is anything to go by, perhaps not entirely.

As a first essential step, the government must step back from the functioning of the banks. It may be justified in setting certain economic priorities, which can then be included in the priority lending list, but beyond that banks must be allowed to take decisions commercially.

The second oft-repeated demand is for governance reforms. The Banks Board Bureau has proved to be ineffective so far. On Tuesday, incidentally, the BBB recommended that the supervisory and management functions of bank boards be separated. If done effectively, this could increase board oversight of bank managements. But the decision to give the BBB greater and more meaningful powers rests entirely with the government.

Finally, the debate on a road map for eventual privatisation of state-owned banks must be revived. The Bank Investment Company has long been seen as a first step towards that aim. That, however, will require political capital which the government may have expended due to demonetisation and GST.

The final judgement on whether the Rs 2.11 lakh crore is termed as a recapitalisation or a bailout, will depend on the government’s ability to follow through on the fresh funding with banking sector reforms. Till then, its the best of bad options.

BloombergQuint
View Opinions From Business And Policy Experts On BloombergQuint