Bank Recapitalization: A Lesson from 1993 (Important)

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Indian government announced ₹ 2.11-lakh-crore capitalization plan for state-owned banks over two years, which solves two problems: Government՚s approach insists on resolving the banking sector problems of NPA՚s by infusing a huge amount of capital.

Bank Recapitalization
  • This funding will not affect the fiscal deficit and is funded through “recapitalization bonds.”

History Lesson

  • Approach first tried out almost 25 years ago when economy was in repair in 1992 - 93 after the balance of payments crisis in 1991 - 92
  • Government unveiled reforms in the financial sector especially after the securities fraud of 1991 - 92.
  • Cash-strapped government made provisions against bad loans of over ₹ 10,000 crore- Manmohan Singh, the then Finance Minister, provided in his 1993 budget, ₹ 5700 crore to public sector banks.
  • Government issued bonds to infuse capital into banks with no cash outgo- the government՚s liability was limited to the interest payment on the bonds and their final redemption.

Details of the Recapitalization Process

  • First government gives money to banks
  • Banks, in turn, buy or subscribe to bonds issued by the government at a fixed coupon or interest linked to market rates for a specified period, 10 or 15 years or longer.

Why Are Such Recapitalization Bonds Useful?

  • These bonds are counted as Tier One or Core capital of banks, critical to maintaining globally accepted standards of capital for banks, which, today, is 9 per cent of their total loans, investments and other assets after factoring in risks against each of these.
  • When bad loans deplete the capital of banks and inhibits their ability to lend, banks can rely on these bonds for liquidity.
  • Government running a deficit but is committed to spending on roads, ports and social welfare measures, doesn՚t have cash to infuse as capital- the bonds come in handy.
  • Bonds provide capital for banks and interest on becomes an income for lenders- when growth picks up, the lenders are in a position to lend afresh.

Costs for Government

  • On ₹ 1.35 lakh crore worth of recapitalization bonds, the interest payment could range between ₹ 8000 to ₹ 9000 crore annually
  • The tangible cost is offset by “confidence impact” of having addressed the issue of lending, boosting credit supply, private investment, and growth.

Do the Bonds Add to Fiscal Deficit?

  • Government is committed to a fiscal deficit of 3.2 per cent in FY18.
  • Although IMF accounting norms say that recap bonds do not increase the deficit but under India՚s convention, these bonds would add to the deficit.

Probable Impact of Recapitalization

  • Theoretically, recapitalization should lead to more lending by banks
  • It is unlikely to increase loan demand because of the low demand for credit now.
  • Capital infusion or fiscal stimulus could ensure a multiplier effect- after banks use part of the funds to provide for bad loans, a good chunk will still be available for growth capital.
  • It will enable PSU banks to compete better down the line.
  • Capital infusion would lead to interest rates fall.

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