Insights into Editorial: A bold step in bank reform

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Insights into Editorial: A bold step in bank reform


A bold step in bank reform

Context:

The Centre unveiled an ambitious plan to infuse ₹2.11 lakh crore capital over the next two years into public sector banks (PSBs). 1.35 lakh cr. will be through sale of recapitalization of bonds.

Introduction

PSBs are burdened with high, non-performing assets and facing the prospect of having to take haircuts on loans stuck in insolvency proceedings. Indiscriminate lending earlier by banks is the main reason for high level of NPAs (non-performing assets).

The government’s capitalisation package for public sector banks will provide a strong booster dose of relief for the capital starved public sector banks.

Why does recapitalizing PSBs a more effective remedy?

With India’s economic growth faltering in the last couple of years, the government has been casting about for ways to galvanise the economy like Demonetisation and introduction of GST. Its economic benefits will be long in coming while the short-term disruption has been very real.

  • Recapitalising public sector banks (PSBs) and enhancing the flow of credit is critical for revitalising India’s growth momentum at a time when the global economy is recovering.
  • The move is vital for the slowing economy as private investments remain elusive in the face of the “twin-balance sheet problem” worrying corporate India and public sector banks reflected in slow bank credit growth.

What is the Twin Balance Sheet Problem of India?

Twin Balance Sheet Problem (TBS) deals with two balance sheet problems. One with Indian companies and the other with Indian Banks. TBS is two two-fold problem for Indian economy which deals with:

  • Overleveraged companies – Debt accumulation on companies is very high and thus they are unable to pay interest payments on loans.
  • Bad-loan-encumbered-banks – Non Performing Assets (NPA) of the banks is 9% for the total banking system of India. It is as high as 12.1% for Public Sector Banks. As companies fail to pay back principal or interest, banks are also in trouble.

Indian PSBs: NPAs and capital needed

Higher cost, lower revenues, greater financial costs-all squeezed corporate cash flow leading to NPAs in the banking sector.

  • ‘Capital’ is a combination of equity, equity-like instruments and bonds.
  • For a given balance sheet, there is a certain minimum of capital that banks must hold. This is called ‘capital adequacy’. The higher the capital is above the regulatory minimum, the greater the freedom banks have to make loans. The closer bank capital is to the minimum, the less inclined banks are to lend. If capital falls below the regulatory minimum, banks cannot lend or face restrictions on lending.
  • When loans go bad and turn into non-performing assets (NPAs), banks have to make provisions for potential losses. This tends to erode bank capital and put the brakes on loan growth.
  • ‘Stressed advances’ (which represent non-performing loans as well as restructured loans) have risen from a little over 10% in 2012-13 to 15% in 2016-17. This has caused capital adequacy at PSBs to fall.

In this context, for bailing out of stressed Banks, the role recapitalization is very significant.

Provisioning of NPA, how it is done by banks?

Provisioning is made by Banks to make up for reduction of asset value in their advances portfolio. The amount is calculated on the basis of RBI guidelines on income recognition, asset classification and provisioning.

Assets are classified into four categories like standard, sub-standard, doubtful and loss.

  • All advances where interest and instalments are served in time are called standard assets.
  • However, where interest instalments are not served for 90 days and more are considered as sub-standard.
  • Assets which remain in sub-standard category for one year are considered doubtful.
  • Apart from these, the assets which are noticed by Bank’s Statutory Auditors and RBI Inspectors, where asset value is completely eroded are considered loss assets.
  • 100% provision is made for both Loss as well as Doubtful assets by Banks.
  • If asset value is unsecured full provisioning is made for unsecured portion of doubtful assets like that of loss assets.
  • In case of sub-standard assets a general provision of 15% of advance amount is provided. However, if advance is unsecured, then an additional 10% is provided as a part of risk management strategy.

Where it is unrealized, legal measures are taken through SARFAESI Act, and DRT (Debt Recovery Tribunal).

What are the causes of deceleration in credit growth?

  1. Poor demand:

Some observers ascribe the deceleration in credit growth to poor demand. They say that corporates have excessive debt and are in no position to finance any investment. This may be true of large corporates. Moreover, demand for investment finance may have decelerated but demand for working capital remains strong.

 

  1. Supply of credit:

                The government has realised that there is a problem with the supply of credit. It has to do          with PSBs’ inability to lend for want of adequate capital.

  • Market estimates had placed the requirement of government capital at a minimum of ₹2 lakh crore over a four-year period.
  • In 2015, under the Indradhanush Plan, the government chose to commit a mere ₹70,000 crore over the period.
  1. PSBs, unlike their private sector counterparts, had lent heavily to infrastructure and other related sectors of the economy. Following the global financial crisis of 2007, sectors to which PSBs were exposed came to be impacted in ways that could not have been entirely foreseen.
  2. The failure to quickly recapitalise PSBs has adversely impacted the economy.
  • It has hindered the effective resolution of the NPA problem and kept major projects from going through to completion.
  • Corporates are stuck with high levels of debt and are unable to make fresh investments.

What is the source of funds for Recapitalization by government?

  • Of the ₹2.11 trillion package, ₹1.35 trillion will be towards issue of recapitalisation bonds. PSBs will subscribe to these bonds. The government will plough back the funds into banks as equity.
  • Another ₹180 billion will be provided as budgetary support.
  • The remaining ₹580 billion will be raised from the market.
  • Analysts believe the package should enable banks to provide adequately for NPAs and support modest loan growth. Once PSBs have enough capital, they can liquidate excess holding of government securities and use the cash to make more loans.

Fiscal impact of the recapitalisation package

Analysts worry about the fiscal impact of the recapitalisation package.

  • International norms allow borrowings for bank recapitalisation not to be counted towards the fiscal deficit.
  • In the past, India has used this accounting practice.
  • The proposed recapitalisation bonds are likely to add to the fiscal deficit unless the government resorts to other practice such as getting the Life Insurance Corporation of India or a separate holding company to issue the bonds.
  • The International Monetary Fund has documented 140 episodes of banking crises in 115 economies in the world in the period 1970-2011. The median cost of bank recapitalisation in these crises was 6.8% of GDP. India’s cost of recapitalisation over a 20-year period is less than 1% of the average GDP during this period.

Way Forward

The government should not worry unduly about missing the fiscal deficit target of 3.2% of GDP. The markets will understand that the fiscal stimulus is well spent.

The government has shown courage in opting for substantial recapitalisation of banks. This is not something that fits into the ‘reform’ mantra whereby private is good and public is bad.

Reserve Bank of India Governor has welcomed the move in effusive terms: “The Government of India’s decisive package to restore the health of the Indian banking system is in the view of the [RBI] a monumental step forward in safeguarding the country’s economic future.”