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Rs.2.11 lakh crore infusion into state-owned banks: How will it be done?

With the announcement of a stimulus package, state-owned banks in India, reeling under bad loans, can now breathe easy

Its common knowledge that our banks, particularly the state-owned ones, are screwed up on account of a mountain of bad loans. And you don’t have to be an expert in banking and finance to figure out why – a lending bubble that became untenable on account of borrowers defaulting on either the principal or interests, or both, simply led to the crisis. As a result, loans which banks usually count as assets because of the interest they help earn, along with the principal amount repaid over the course of years, have become non-performing assets.

Consequently, banks have seen their balance sheets being affected since they are required to provision against the bad loans to cover for possible defaults. This has severely restricted their ability to lend, which in turn has affected the private sector that needs funds from them for business expansion. Eventually, this got the economic growth of the nation got screwed up too, amply corroborated by the latest GDP figure, which stood at a three-year low.

In order to fix the serious problem, the government has finally come up with a rescue plan worth about Rs2.11 lakh crore (equal to $32 billion). It intends to inject the money into public sector banks (PSB) so as to pull up their capital adequacy levels (CAR), which is the ratio of a bank’s capital with respect to its risk weighted assets and current liabilities. CAR is fixed by the central bank of a nation to prevent its commercial banks from taking excess leverage and becoming bankrupt as a result. In many public sector banks, the CAR is close to sinking below regulatory requirements.

With the stimulus money, it is hoped the banks will be able to lend again and thus get the economic machine roaring.

While the news has been welcomed by the banks whose stocks soared immediately, sceptics worried it would widen the fiscal deficit. But, in its defence, the government claims the fiscal deficit will not be affected much.

And how, you may be wondering? Well this is how it could play out going by history (a similar stimulus programme was carried out by the government in the 1990s, when billions was funnelled into banks via recapitalisation bonds) and by the statements made by finance minister Arun Jaitley:

A major chunk of the Rs.2 lakh crore – about Rs.1.35 lakh crore – will be pumped in through bonds, termed as “Recapitalization Bonds,” this time around too. The government will most likely issue the bonds through a holding company created specifically for the purpose. The bonds will have to be bought by banks. This will lead to the flow of money from the banks to the government as it will make the banks lenders and the government borrower.

So how at all will it achieve the purpose of recapitalisation of banks since they will have to drain their savings to invest in the bonds?

Well, the government will then buy shares in these banks, so the banks will get their money back.  They will have sufficient capital again to work with. This step is meant to ensure that the bond market is not impacted by such a large issuance. Besides, since there would not be any direct cash infusion (the whole exercise would thus be cash-neutral), the fiscal deficit will not be affected.

The interest payment on the bonds, however, could lead to a fiscal deficit. But, if the banks perform well and clock in handsome profits, it will lead to higher dividends for the government for the shares of PSBs they invest in. This, in turn, would offset the interest burden from the recapitalisation bonds.

Besides, the bonds could be marketable, meaning in case the banks require liquidity, they could sell those in the market to raise cash for either lending or to write-off loans. But, such securities will need to have an equity element. At present additional tier-I bonds (also known as perpetual bonds) have equity-like features under Basel-III framework, wherein they have no maturity date and can continue to pay coupon forever.

The recapitalisation bonds issued by the government is particularly targeted at banks that have a lot of deposits on hand on account of the demonetisation exercise of the government last year. As per Reserve Bank of India estimates, almost Rs.2.8 lakh crore to Rs.4.3 lakh crore of excess deposits landed in the banks due to the note ban. It is this excess deposits that the banks are expected to use to buy the recap bonds.

The government is yet to reveal further details about the structure and pricing of the bonds.

Of the remaining Rs.76, 000 crore, the government will buy Rs.18, 000 crore worth shares of public sector banks through budgetary allocations. Another Rs.58, 000 crore the banks are expected to raise from the financial market. Thus, overall it will be a government-private infusion of money into the state-owned banks.

If the plan pans out properly in the two years’ timeframe, the PSBs will not just be able to provision for the loans adequately but also be able to bring about capital growth. This would support credit growth, private sector expansion and eventually lead to job creation.