What is it?

The government has announced a capital infusion in public sector banks amounting to ₹2.11 lakh crore over financial years 2017-18 and 2018-19 through the issue of recapitalisation bonds, enabling the banks to tap the market, and through budgetary support. Of this sum, ₹1.35 lakh crore will come through recap bonds, ₹18,000 crore from the budget and ₹58,000 crore that banks can raise from the market. However, the government is yet to decide on the modalities of the recap bonds.

The government has issued recapitalisation bonds in the past, between 1986 and 2001, worth over ₹20,000 crore. The process typically is that the government issues the bonds to banks in lieu of capital. After lenders subscribe to these bonds, the money raised by the government is used to infuse fresh equity into the banks. Except the interest that has to be paid, there will not be an additional burden on the government. It is likely to have a marginal impact on fiscal deficit.

Reacting to the move, RBI Governor Urjit Patel said the capital infusion would be “liquidity neutral for the government,” except the interest expense that will contribute to the annual fiscal deficit. He pointed out that a well-capitalised banking system was a pre-requisite for stable economic growth. Similar bonds have been used by many countries, including Chile, the Philippines, Finland, Hungary, and Argentina.

Also read: The stimulus and after

How did it come about

Reeling under the pressure of bad loans for the last three years, capital has eroded significantly in public sector banks. These banks are overly dependent on the government for funds due to their limited ability to tap the capital market because of the subdued valuation of their share price. Most of the public sector banks’ shares are trading at a discount to their book value. However, the government is also constrained to make a significant capital allotment from its budget, since it wants to stick to the path of fiscal discipline. The Finance Minister has pegged the fiscal deficit target at 3.2% of the GDP. So, recap bonds were an option which fulfilled both objectives: supporting banks with their capital needs but without disturbing the fiscal math.

According to a report by State Bank of India, from 1986 to 2001, the interest paid by the government to the nationalised banks on recap bonds worked out to 0.07% of GDP per annum on average. But during the period, the banks paid dividends to the government amounting to 0.06% of the GDP on an average. So, the net impact on fiscal deficit was only 0.03% of the GDP.

Also read: Pursuit of growth: On PSB recapitalisation

Why does it matter?

The move will strengthen the capital adequacy of public sector banks, which is required for provisioning for bad loans and adhering to the Basel-III framework. Following a sharp increase in bad loans, which is almost 10% of the banks’ advances, the capital position of the public sector banks has weakened. In the past two years, NPAs have increased to ₹4.55 lakh crore. The banking system is saddled with bad loans and stressed assets close to ₹10 lakh crore. As the banks were wary of lending, credit growth slipped to a 60-year low of 5% in April. Analysts and rating agencies claim the capital infusion will be sufficient for public sector banks. Pointing out that the funds infusion would be credit positive, rating agency Moody’s said external capital requirements over the next two years would be around ₹70,000 crore-₹95,000 crore for 11 banks rated by the agency.

“In addition to the fact that Moody’s estimates of capital requirement is for only the 11 rated banks, while the government factors in the entire PSU bank universe, the government’s estimate of capital requirement could also be factoring in a much higher loan growth than was seen in the last three years,” the agency said.

What next?

While capital infusion is welcome, it must be ensured that the government is not throwing good money after bad money. Improving credit discipline and risk management systems are the need of the hour for public sector banks. The governance issues of the banks and their over-enthusiastic lending in the past, for instance, need to be addressed.

The government should initiate long-pending reforms, especially those recommended by the P.J. Nayak Committee that said, among other things, that it cede control of nationalised banks and cut its stake below 51%.