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Government’s Rs. 2.11 trillion bank recapitalisation— Sufficient to cover stressed assets but no quick fix

Thursday, November 2, 2017 1:28

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The government, the largest shareholder will recapitalise the banks it owns by infusing an unprecedented amount of Rs. 2.11 trillion (US$32 billion), of which Rs. 1.35 trillion will be through recapitalisation bonds. Infusion of capital would help to fast-track the resolution of non-performing assets (NPAs) and take Indian PSBs closer to global capital adequacy norms. The move is expected help economic recovery with the revival of flow of credit to business and industry, and particularly foster medium and small industries growth and employment generation.

Public sector banks require capital mainly because of a sharp rise in NPAs in the last decade due to delays in repayments from sectors like power, steel and infrastructure. The gross NPA ratio reached 9.7 per cent in FY17, up from 7.8 per cent in FY16. Including loans that have been restructured the ratio of stressed loans rises to 12% of total banking sector loans. Weak credit discipline in banks, right from the appraisal to sanction stage, was recognised, by the RBI, as one of the main bank specific factors in the build-up of stressed assets. Swift, time-bound resolution or liquidation of stressed assets was recognised as critical for de-clogging bank balance sheets and for efficient reallocation of capital and a multi-pronged approach taken. The Asset Quality Review (AQR) exercise undertaken in 2015-16 was a critical step in recognising the aggregate stock of NPAs across the banking system. Setting up of CRILC (Central Repository of Information on Large Credits) by the RBI in 2014, gave access to an aggregate view of borrower-wise and bank-wise exposures, to supervisors as well as lenders, to track the incipient stress in a particular account in a timely manner. The decision to do away with the regulatory forbearance regarding asset classification on restructuring of loans and advances effective April, 2015, was a significant step from the perspective of aligning the regulatory norms with international best practices. The system of ‘Prompt Corrective Action’ (PCA) ensures timely supervisory action in case banks breach certain risk-related trigger points. The enactment of the Insolvency and Bankruptcy Code, 2016 (IBC) puts a time limit of 180 days (extendable by a further 90 days) within which creditors have to agree to a resolution plan, failing which the adjudicating authority under the law will pass a liquidation order on the insolvent company (https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1044).

The necessity for capital infusion had also been emphasised by various rating agencies such as Moody’s, CRISIL and Fitch, as well by RBI insiders. Moody’s estimated that the external capital requirements for the 11 rated PSBs, over the next two years would be around Rs. 700-950 billion, factoring in the two main drivers of their capital needs—the need to comply with Basel III requirements, and for conservative recognition and provisioning of their asset quality problems.Such an amount is much higher than the remaining Rs.200 billion previously budgeted by the government for capital infusion until March 2019. Under Basel III norms, being implemented in phases between April 2013 and March 2019, banks need to have a core capital ratio of 8% and a total capital adequacy ratio of 11.5% against 9% now. Capital adequacy is a measure of a bank’s financial strength expressed as a ratio of capital to risk-weighted assets (CRAR). A number of single factor sensitivity stress tests, based on March 2017 data were carried out, by the RBI, on SCBs to assess their vulnerabilities and resilience under various scenarios. SCBs’ resilience with respect to credit, interest rate, and liquidity risks as also due to drop in equity prices was studied. A severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks. Under a severe shock of 3 standard deviations (that is, if the average GNPA ratio of 59 select SCBs moves up to 15.6 per cent from 9.6 per cent), the system level CRAR and Tier-1 CRAR will decline to 10.4 per cent and 7.9 per cent respectively. At the individual bank-level, the stress test results show that 25 banks having a share of 44.4 per cent of SCBs’ total assets might fail to maintain the required CRAR under the shock of a large 3 standard deviations increase in GNPAs. PSBs were found to be severely impacted with the CRAR of 22 PSBs likely to go down below 9 per cent.

The government is yet to disclose details on the structure and pricing of the Rs. 1.35 trillion recap bonds, as well as how it will raise the rest of the cash. It is expected that banks will subscribe to these bonds and hold it on their books as their investment. The funds which will go to the government will be reinvested as equity in the same banks. The programme is expected to have minor impact on its target to shrink the fiscal deficit to 3.2% of GDP in FY18, because the government will probably classify the bonds as off-balance sheet items as per permissible accounting norms. However, the government still has to bear the interest cost; to service the debt it will need to at least bear a cost of Rs. 80-90 billion, according to various unofficial estimates. Apart from the recap bonds, Rs. 0.18 trillion will come from the budget, in line with earlier provisioning under the Indradhanushscheme, leaving Rs. 0.58 trillion to be raised from the market. Front-loading of bonds is expected to increase the equity prices of PSBs. Rating agencies have called the government’s Rs. 2.11 trillion PSU bank recapitalisation plan significantly credit positive. Post the announcement, the 30-share BSE Sensex gained 387.96 points to open on 32,995.28 and the 50-share NSE Nifty gained 113.45 points to open on 10,321.15. Both the indices extended gains with Sensex breaching the 33,000-mark to touch the peak of 33,117.33 and Nifty scaling a fresh high of 10,340.55. PSU Banks were leading the rally in early trade with the Nifty PSU Bank sub-index jumping 22.76 per cent Most public sector banks’ shares have surged more than 20% since the announcement by the MoF.

However, apart from the modalities of the plan, questions that arise relate to its actual effect on the bond market, on governance issues of banks and its actual impact on the economy. The bond market faces a formidable supply load, even in the face of excess liquidity now being managed by RBI. Such large scale financing, though executed over two years and possibly held on books, could nevertheless, hamper the ability of the biggest subscribers, the PSBs, to invest in bonds and may push up yields eventually when liquidity dries up. A series of banking reforms are to accompany the capital infusion, however, doubts definitely arise about moral hazards of such bail-outs as past experience of the 1990s has demonstrated that banks have not been able to shore up their lending practices so as to stem further build-up of toxic assets. Further, at this stage there are uncertainties about the appetite of borrowers with large overcapacities on GST implementation, and hence capital freed up for lending may not have immediate takers and not have much of the desired effect on economic revival. Again banks too may prioritize asset resolution and provisioning over expansion. Hence, the measure announced should not be seen as a one-shot solution to the banking sector’s and the economy’s current aliments, but rather as an important part of an integrated process, which still needs much careful planning and monitoring at each stage.

Source: http://ecofin-surge.blogspot.com/2017/11/governments-rs-211-trillion-bank.html

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