Open the floodgates

Indian banks need a capital flood, not a dribble

India's piecemeal approach to fixing its banking sector is flawed. The government says it may double the amount it will inject into state lenders to $3 billion this year, and double it again next year. Though the increase is welcome, it's still a fraction of the $50-odd billion that government-controlled banks may need to fix their balance sheets and meet new capital requirements. India needs to be more aggressive.

The current hand-to-mouth strategy is understandable but unworkable. Narendra Modi's government has sought to cut the cash it hands over to banks and only allocate funds to those institutions that met certain return targets. It has also encouraged banks to go out and raise capital. The problem is that weak earnings and a slower-than-expected pickup in the economy means few banks are able to attract outside investors. The government's reluctance to reduce its shareholdings below 50 per cent is another hurdle. A drive to improve governance will take more time.

The state banks desperately need more equity. They dominate a national banking system where more than 10 per cent of assets were stressed as of March 2015, according to credit ratings firm ICRA - and that's just the ones lenders admit to. The real number may be twice as high. Even if state banks set aside sufficient provisions to just cover existing impaired loans, Morgan Stanley analysts estimate that the core Tier 1 capital ratios of the institutions they cover would fall to between 4 and 7 per cent. The problem is likely to be even worse for the smaller, weaker, public sector lenders.

The government already missed a prime opportunity to tackle the problem when the stock market soared on hopes of economic reform. Investors have since tempered their enthusiasm: some bank shares have fallen by more than a third this year. Capital could become even harder to find when the US Federal Reserve raises interest rates.

A much larger recapitalisation would widen India's fiscal deficit. But it would also ensure that the banks are ready to fund the country's investment cycle when it eventually picks up. The government's piecemeal approach risks dragging on India's growth.