What is happening is the public sector banking space in India?
The government of India (GOI) has recently announced the plan to recapitalize public sector commercial banks (PSBs) by injecting a fresh capital of 2.11 trillion rupees. This is no doubt a surprise move. As the largest recapitalization initiative for PSBs by GOI in the last 4 decades, it has significant implication from social, political and economic perspectives. In this article we shall try to understand this decision in its context.
Public sector banks and Indian economy
PSBs are scheduled commercial banks owned by GOI with majority shareholding; more than 50% of equity shares are held by government. At present there are 21 PSBs and majority of them were taken over in 1969 through a bank nationalization initiative. Prior to that, Indian banking industry was primarily privately owned; social agenda were not in the banks’ list of priorities. Farmers, small businesses, retail traders and self-employed professionals had to rely on expensive private lenders as they were not conventionally creditworthy from banking perspective. Government’s decision to nationalize banks was motivated by the social agenda of making affordable credits accessible to general public and thus promoting economic equality and growth. This agenda has often dented profitability of PSBs and for that reason the Government has recapitalized these banks from time to time to keep their financial health intact.
Banking industry and the importance of capital in banking business
Unlike manufacturing, trading, construction, services or any other businesses, only banks are allowed to accept deposits from general public and lend money to borrowers. The difference between interest paid on deposits and interest received on lent amount is the earning to a bank.
Risk arises when borrowers default in paying back or depositors go for early withdrawal or both happen simultaneously. In such situations, a bank might fail to meet its commitments due to lack of liquidity.
To mitigate these risks all banks are required, by regulation, to maintain a minimum capital balance in their balance sheets. Unlike deposits, capital in banking plays the role of reserve; it helps to overcome unforeseen crunch events; can be used to write off losses; has least priority in terms of maturity. For equity capital, there is no obligation to pay dividend too. So, banks don’t need to set aside or spend extra money.
Along with risk mitigation, excess capital, above the minimum balance, helps banks to increase lending without relying on the growth in deposits. So, recapitalization in the form of adding fresh capital or increasing the percentage of equity share in capital structure is very important for business stability and growth of any bank.
What is the recent situation in Indian banking sector?
In terms of branch outreach, deposit accumulation, number of account holders or credit disbursement, collectively public sector banks are still the major players in India. Obviously, the same is true for the share in non-performing and stressed assets.
As a quick reckoner, NPAs are loans and advances for which the borrowers failed to repay interest due or the principal amount due within a specified time period of 90 days in India. Depending on how long a loan remains unpaid, an NPA can be classified again qualitatively into:
- substandard asset,
- doubtful asset, and
- loss assets
Stressed asset is combination of NPAs, restructured debts and debts already written off, which are irrecoverable, from the book. So, stressed asset in a bank’s balance sheet clearly indicate its financial health.
As per recent declaration of Reserve Bank of India (RBI), gross non-performing asset (GNPA) of PSBs stood at 7.34 lakh crore rupees by the end of 2nd quarter of 2017-18. And out of that, nearly 77% of NPAs are for the loans and advances to corporate houses and companies. This is a major concern as these loans and advances were primarily extended out of purely business profitability motives, unlike the obligatory loans to socially relevant players.
This has given rise to the perilous situation called ‘twin balance sheet’ problem in Indian economy. NPAs and stressed assets are jeopardizing banks financial health in one hand and on the other hand, initiatives to recover those bad debts are pushing corporates and companies towards bankruptcy and liquidation risking overall business health of the economy. So, the ongoing trend in NPAs and stressed assets in banking system is more difficult to tackle than it seems.
What is the reason behind failure by Indian corporates to repay their debts?
There are various theories and explanations; some are motivated and some are factual. Let us have a quick look up.
- As per the 2016 data released by RBI in its Financial Stability Report, basic metal and metal products, construction, textile, infrastructure and engineering are some of the major contributors in total Gross NPA. Simultaneously, these are some of the industries which got badly beaten in the recent economic slowdown. Demand for housing has remained laggard for consecutive years affecting viability of construction industry projects. Same is true for infrastructure with various stalled mega projects. These have affected capital goods, steel industry. Metal sector also suffered sharp price correction in international markets due to global melt down. So, business cycle is surely a major reason behind accumulation of NPAs for majority of the cases with Indian corporates.
- Poor credit appraisal process cannot be completely denied. PSBs, often due to short term revenue gains or ulterior motives, approved projects without proper risk assessment or overlooking certain risks or diluting certain risk-return payoffs. These were assets with already compromised quality; as a result recovering these debts have become doubtful.
- Along with all these, there are a few cases of big ticket intentional defaults, which took benefits of legal loopholes, inadequate or flawed recovery mechanism and malpractices by the stakeholders.
Measures taken by the Government
Accepting the ‘twin balance sheet’ challenge, GOI has been taking measures for both the side – debtors as well as creditors in the recent years. For an example, to support distress steel sector, the government increase import duty on steel products, imposed additional safe guard duty along with stipulation of minimum import prices.
To support banks in recovering their bad loans, the network of Debt Recovery Tribunals (DRTs) have been expanded from 33 in 2016-17 to 39 in latest fiscal. This will help to cut down number of pending cases as well as fast disposal of cases. Recently updated time-bound insolvency resolution process is going to support banks with debt restructuring and other effective recovery options.
For improving banking financial health, recapitalization targets have been taken. Already Rs. 25,000 crore has been injected in 2015-16 and 2016-17. The latest decision of recapitalization of Rs 2.11 lakh crore is a continuation of the same initiative. This will be done in 3 stages;
- Through budgetary allocations: Rs. 18000 crore
- Through issuing equity shares in market by banks: Rs. 58000 crore
- Through recapitalisation bonds by GOI: Rs. 1.35 lakh crore
The latest recapitalization decision will not just take care of minimum capital adequacies in public sector banks but will also give deserving PSBs enough leeway to improve supply of fresh credits in the economy. Recent pile up of NPAs and stressed assets have already dampened credit disbursement mood in the banking sector. With limited capacities of private and foreign banks, PSBs have to take the leading role again for bringing in credit liquidity in the system. And this fresh supply of capital is going make that possible. However, along with recapitalization we also need proper implementation of risk management system in PSBs and enough check and balances to stop spurious practices from popping their heads up again.