Bank Recapitalization – A Welcome Move

Bank Recapitalization

Last month, the government announced its major initiative to help strengthen banks ridden with stressed assets and weak balance sheets. Recapitalization is key in this process. This process is expected to have a significant impact on the economy as it clears the blocks in the credit creation process.

The origin of the current predicament is popularly called the ‘Twin Balance Sheet’ problem – something that the Chief Economic Advisor brought to limelight in the 2014-15 Economic Survey. The twin balance sheet problem refers to the impact of problems of stressed assets on over-indebted firms as well as banks. As firms are ridden with debt, they are unable to borrow to get out of the situation. This has an impact on the banks as they are unwilling to lend as assets become stressed. The net impact of the Twin Balance Sheet problem is the impact it has on credit creation – the key driver of modern economies. This further goes on to affect the growth of economies. Japan is a case in point where its ‘lost decade’ soon turned into two!

The CEA, Arvind Subramanian has popularized his approach to resolving this Twin Balance Sheet problem. He calls it the 4 R’s. Recognition, Recapitalization, Resolution, and Reform.

The recognition process started under Governor Raghuram Rajan as the RBI pushed banks to more accurately recognize the extent of stressed and non-performing assets they had. This involved bank recognizing their assets at a ‘true value’. This has an impact on their capital position. Hence, there arises the need to recapitalize the banks. On the other hand, the ‘resolution’ of the root cause also needs to be addressed. This involves the selling off these stressed assets as well as the assets of the firms to meet the liabilities and clears the banks of the problem. The last part of reform is to ensure such a situation is avoided in the future.

It is important keep in mind that recapitalization is just one part of the government’s strategy. The government has acted keeping in mind the long-term health of the economy. The Bankruptcy Code is also a crucial piece in this ‘puzzle’. The RBI Governor said “For the first time in the last decade, we now have a real chance that all the policy pieces of the jigsaw puzzle will be in place for a comprehensive and coherent, rather than piecemeal, strategy to address the banking sector challenges”. This shows a significant shift in the way the economy is evolving. Many in the government have spoken of a shift in the approach of governance to a more rule based economy.

The recapitalization plan has a two-year time horizon and has three elements: One, the government will buy Rs. 18,000 cr. worth shares of Public Sector Banks; two, Public Sector Banks will need to go raise Rs. 58,000 cr. from the market; and three, the government will issue a vaguely worded thing called “Bank Recapitalization Bonds” for Rs. 135,000 cr. which will be used to buy more shares in Public Sector Banks.

Part of this plan also involves getting dividends from PSUs to finance the process. The financial burden of the recapitalization bonds would be the interest payment of about Rs. 8000-9000 crores. But this cost is negligible. The government has made substantial notional gains since it announced the recapitalization plans as the share prices shot up by double digits. There is also the second order impact of this processes allowing growth to take place and so on. This would put pressure on the fiscal deficit.

This isn’t the first time that such a thing is happening in India. The government has issues such bonds in the past to help recapitalize banks. From FY1986 to FY2001, the government recapitalized public sector banks (PSBs) to the tune of almost Rs20,446 crore. NPA are a part of the business cycle. Not all loans which are made in times of optimism and exuberance come back in full. With fluctuations in business cycles (industry specific or general cycles), firms are affected. This is an occurrence throughout the world. Many other countries have also employed such methods to help to financial and banking system. Algeria, Ecuador, Hungary, Tanzania, Poland, Uganda are some of the countries that have employed such methods.

All in all, this is a very welcome move. The government’s long-term view and strategic thinking in this sphere is appreciable — something that has been reflected in India’s credit rating as Moody’s has upgraded it from Baa2 to Baa3.

-Contributed by Bhargav Dhakappa

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