Necessary, not sufficient

Governance reforms must follow bank recapitalization

The Union government on Tuesday announced a plan to recapitalise struggling public sector banks in order to break the vicious cycle of rising non-performing assets (NPAs) that are constraining fresh lending – India’s banking credit growth is at the lowest in 25 years – which, in turn, is holding back the revival of private investment. After being in denial for long, the government is finally trying to provide the necessary support to these banks, which account for 70 per cent of Indian banking, through a Rs 2.11-lakh-crore recapitalisation plan spread over two years. So there is merit in the enthusiastic welcome by Reserve Bank of India (RBI) Governor Urjit Patel of the plan. In a statement, Mr Patel said for the first time in the last decade India had a real chance that all “the policy pieces of the jigsaw puzzle would be in place for a comprehensive and coherent, rather than piece-meal, strategy to address the banking sector challenges”.

After the RBI under former governor Raghuram Rajan ruthlessly enforced an asset quality review on banks, forcing them to recognise NPAs and provide for them, public sector banks have started sliding down the viability scale. One quarter after another, banks, especially state-owned ones, have been acknowledging a rising level of stressed assets, and the resulting provisioning has wiped off the bulk of their profits. The worst affected are the public sector banks, which have the largest exposure to sectors such as infrastructure. As time went by, the government faced a stark choice: Either privatise some of the sinking public sector banks or recapitalise them. While the first option was a political minefield, the second was extremely difficult given the fiscal deficit situation.Against an estimate in August 2015 of Rs 1.8-lakh-crore recapitalisation needed by the end of 2018-19, the government has infused just Rs 51,858 crore in public sector banks.

Many of the crucial details of the recapitalisation scheme are yet to emerge but there are some pointers, such as the ones in Mr Patel’s statement issued on Wednesday. For instance, he said the bonds to be issued are likely to be liquidity-neutral and though there will be a bump up to the deficit, it is expected to be marginal and limited to the extent of the interest paid out on such bonds. Chief Economic Advisor Arvind Subramanian, though, has a different take: Under India's accounting practice, which is different from that of the International Monetary Fund, the government bonds will not only increase government debt but will also be counted towards the fiscal deficit. Also, finance ministry officials say that the allocation of fresh capital will be contingent on how efficient banks have been in using their capital and dealing with NPAs. So does this solve at least one half of India’s “twin balance sheet” problem? The answer is not easy. While the massive recapitalisation will help public sector banks to deal with the lending challenge, there are two associated issues. One, it is debatable whether the main constraint was the supply of loans or the demand for them. The second issue is even more serious, as the government has to now focus on pending governance reforms in public sector banks. Without that, there is no guarantee that the fresh capital will be lent wisely.