Avoid PSB recapitalisation pitfalls

The govt must announce the criterion for capital allocation without delay

The government’s Rs 2.11-trillion recapitalisation plan for public sector banks (PSBs), although widely welcomed, carries a risk that history may repeat itself. This is the moral hazard of recapitalisation.

The comfort that the government would again bail them out may lead PSBs to resort to inadequate project appraisal and credit monitoring, and again land up with burgeoning non-performing assets (NPAs) down the road. Additionally, incentive by way of higher capital by reckless credit provisioning cannot be ruled out in the near term. This has to be avoided at any cost, but more of it later.

For now, recapitalisation benefits seem manifold, if it is successfully implemented in a time-bound manner. Solving gross NPAs and the stressed assets problem will help PSBs to fulfil their regulatory capital adequacy norms and improve their credit profile, permit them to expand their credit (lending) book and thereby lead to faster economic growth, kick-start investments and create more employment opportunities.

Recapitalisation can improve the provision cover beyond 50 per cent of the stock of PSBs’ gross NPAs as on June 30, 2017, from 43 per cent as on June 30, 2017. Besides, the stressed assets resolution process will gain momentum resulting in an enhanced ability of the banks to absorb credit losses. The PSBs’ willingness, too, will matter.

Capital infusion and consequent cleaned balance sheets would attract more investors to the PSBs, improving their ability to raise growth capital from markets. Once lending picks up, PSBs will have adequate capital to fund growth and cover newer NPAs which cannot be ruled out.

One would know more accurate assessment of the credit positives of individual PSBs over time, after the size of capital infusion in each bank has been determined. It is assumed that the government will follow criteria-based capital infusion though it may have to provide higher support to weaker banks so that they have adequate capital to meet the regulatory capital levels.

Dependent also on the capital infusion is the likely upgradation of PSBs’ credit profile, apart from the outcome of the resolution process on stressed accounts and improvement in their earnings and solvency levels. Also, ratings of their Additional Tier I (AT-1) bonds, which are serviceable based on the capital levels and earnings (including retained earnings), will remain vulnerable to continued losses and erosion of retained earnings (which can be used to service coupon on AT-1 bonds in a year of loss) implying higher risks of coupon defaults for the weaker PSBs, irrespective of their recapitalisation.

In all likelihood, recapitalisation will create more competition amongst banks (along with other financial intermediaries) to boost their share of lending as and when credit demand rises; PSBs may resort to more aggressive lending.

Recapitalisation is likely to delay the PSBs’ consolidation process; however, the willingness of weaker PSBs to merge in a situation of better capital position remains to be seen. Consolidation may be quicker if they are given limited capital, just sufficient for meeting regulatory requirements, thereby making growth a function of their profitability and ability to generate internal capital. In such a scenario, stronger PSBs may be more forthcoming to acquire weaker PSBs as the latter may not any longer be a drag on their profitability and capital levels.

Coming back to the question of moral hazards, as of now though the government intends to follow a criterion-based approach, there have been deviations with higher support to weak PSBs to prevent a breach of regulatory capital. A few past instances indicate higher capital allocation to the weaker PSBs and curtailment of growth capital to stronger PSBs.

Therefore, the government needs to announce the criterion for the capital allocation and the share of the capital for each bank without delay. Further, any capital beyond the criterion-based level should be strictly scrutinised, as it may be detrimental to the wider interest of the economy and the sector.

Going forward, banking reforms should be pursued in all seriousness without delay. Though more clarity on banking reforms will be awaited, the chief economic advisor has hinted at recognition of true and fair value of PSBs’ assets, protecting capital erosion through incremental capital infusion and a quick resolution of the corporate sector’s stressed assets under the new Insolvency and Bankruptcy Code through liquidation or rehabilitation. If these are adhered to, only then can we hope of financially stronger PSBs contributing towards a resilient Indian economy.

The author is group head, financial sector ratings, ICRA Ltd