Recapitalisation - Why do Banks need to Recapitalise?

The Centre on October 24, announced a re-capitalisation plan of ₹2.1 lakh crore, unveiling a two-year roadmap to strengthen NPA-hit public sector banks, which includes re-capitalisation bonds, budgetary support, and equity dilution.

Why do banks need to recapitalise?

It’s like this. Banks create money. They can create money at will really. If I lend you money, and you put it back in a deposit in my own bank, I have created money.

Now, what constraints banks have, is their capital. For every loan I make, I need to have 10% of it as my capital. So if I have Rs 100, I can give out Rs 1000 in loans.

Now if I lose Rs 50 on those loans because some fellow defaulted (5% NPA) then my loss hits my capital. My capital falls to Rs 50.

Now I have only Rs. 50 on Rs. 950. So at this point, I have to raise capital to come back to 10% capital ratio. Or, I have to somehow call in loans. Calling on loans isn’t possible so I stop lending more.This is what has happened.

Public sector banks have frozen up on lending because they can’t lend more, as their capital ratios will not allow any more.

Banks have Rs 100 capital and have lent Rs 1500 (6% capital ratios) They have losses of Rs 50 they know about and are unwilling to take (net NPAs). So the government gives them Rs 50. Their capital increases to Rs. 150. Then they take the Rs. 50 loss.

So now they have Rs 100 capital on Rs. 1450 lent which is a better capital ratio than before.

Because of better capital ratios, banks can now raise more capital – say another Rs 50 is raised. Now they have the ability to lend another 500 rupees, to maintain say an 8% capital ratio.

Effectively, what the government wants to do is force banks to take losses by pushing NPAs to real losses, as the government replenishes the capital that is lost.

The recapitalisation programme for public sector banks is likely to boost equity market sentiment as it fuels growth recovery hopes, though the recapitalisation amount may create a supportive environment for growth, it may not drive growth by itself.

Given that over the last five years, the Centre has infused about ₹89,000 crore (2012-2017) into PSBs, the bounty is sure to please the markets. But given that the capital the Centre has infused over the past several years has not aided growth and only helped banks fund losses on account of huge loan defaults, there is an urgent need to also start structural reforms within the sector.

While the main aim of the Centre’s step is to boost lending activity, going by past data, capital infusion alone cannot ensure credit growth, structural changes at SOE banks (State – Owned – Enterprise) in terms of HR practices, incentive structures and independent boards need to be followed up.

The current love of capital infusion in PSBs entails mobilisation of capital, with maximum allocation in the current year, to the tune of about Rs 2,11,000 crore over the next two years, through budgetary provisions of Rs 18,139 crore, and recapitalisation bonds to the tune of Rs 1.35 lakh crore. The overall loan growth for all PSBs put together was an only 2 percent in 2015-16, even as the Centre infused around ₹20,000 crore during the year. The trend has been no different in 2016-17, with loan growth for PSBs still a meagre 1.9 percent.

The recent CRISIL report stated that banks need to keep aside 3.3 lakh crores as NPA provisioning in FY18, which is 50 percent more than that of last fiscal (2.2 lakh crore). This reveals that the Centre’s funds have gone mostly to fund banks’ losses on account of huge loan defaults.

Having said that Centre’s capital infusion, even this time around will continue to fund these banks’ losses rather than growth for some time. As a fire-fighting measure, the Centre’s recap plan can help banks clean up their balance sheets and prepare themselves for the next period of lending.

As a matter of fact, the Centre’s recap plan did have a great short-term impact on the stock markets. After the announcement on 24^th October, markets reap dividends on 25^th of October. The recap news lifted the spirits of share markets, where the BSE SENSEX closed over the 33,000 mark for the first time and Nifty scales new high as stocks of PSBs record gain.

However, The Centre’s decision to recapitalise banks with government bonds worth Rs 1.35 lakh crore is nothing but the taxpayer bailing out India’s public sector banks whose capital base stands eroded because of mounting loan defaults by 50 large corporate groups.

Though the government says this won’t increase the fiscal deficit as no cash outflow is involved, it does have other effects of a higher fiscal deficit such as increased interest payment by the government on the bonds issued to banks. Let us now hope that the higher fiscal deficit would not add to the demand-side pressure, and there will be a negligible impact on CPI inflation.