(As I write this, the opportunity cost of holding all the stocks in my portfolio has shot up by more than 20%. But, I am still mired in the sunk cost fallacy, and decide to hold onto them)
First things first, what is an NPA?
I am a bank. I give a businessman ₹1 crore to invest in his business. Yay. I added an asset in my books. The asset, by definition, would be a source of income for me in the future. (That’s why I gave him the money in the first place) I am happy.
The businessman invests the money I gave him, but he is not able to generate returns from the amount. (In some cases, he doesn’t really care and might decide to fly to UK) As a consequence, he is not able to pay me my interest (and principal). He keeps on doing this for 90 days. The businessman was supposed to perform so well on my behalf, becoming a source of my future incomes. But, he has not performed as per my expectations.
I decide to take revenge. But all I can do is to add an adjective in front of the accounting entry. I add ‘nonperforming’ before ‘asset’ and that’s that.
Nonperforming assets or NPAs as they are conveniently called, have performed outstandingly well when it comes to troubling some of shrewdest bankers and economists of the country. Their existence is not necessarily bad, it’s just the extent of them that can be terribly bad. Any bank that lends money to a business quite innocuously assumes some risk of the business going bust. However, in business (and in life), you progress by taking on such risks. Though the real problem comes when the rewards are not commensurate with the risks you are taking.
Some numbers to understand the severity of NPAs…
Indian PSBs are sitting on the stressed asset pile of close to ₹10 lac crore. NPA ratio (Net NPA/total advances) for Indian banks is at 9.1%. Brazil, South Africa and China have 3.8%, 3.2% and 1.7% NPA ratio.
The table reflects the poor condition of Indian PSBs. Since PSBs account for close to 70% share in the bank lending, the dismal condition of theirs is particularly worrisome.
|Name of the bank||Bad loans ratio (in percent)||Name of the bank||Bad loans ratio (in percent)|
|IDBI Bank||24.11||Allahabad Bank||13.85|
|Indian Overseas Bank||23.6||Punjab National Bank||13.66|
|UCO Bank||19.87||Bank of India||13.05|
|Bank of Maharashtra||18.59||Union Bank of India||12.63|
|Central Bank of India||18.23||Bank of Baroda||11.4|
|Dena Bank||17.37||Canara Bank||10.56|
|United Bank of India||17.17||State Bank of India||9.97|
|Corporation Bank||15.49||Syndicate Bank||9.96|
|Oriental Bank of Commerce||14.83||Indian bank||7.21|
Banks sitting on such a huge pile of bad debts would be suspicious of any and every potential borrower. Even the good ones. ‘Problem of lemons’ takes effect and banks miss out on the opportunity to lend even to the capable borrower. Already piled up bad debts and resulting non-generation of good debts results in a bad Nash equilibrium. But, an equilibrium nonetheless.
Surely the Government had to come up with something to address this issue. What is that it has come up with?
In the parlance of ‘financial engineering’ (Two fields often assumed to be independent, with the former being studied by most to escape the latter), what government has done is called Recapitalization.
Sounds fancy. How do you implement it?
- Government will issue something called Bank Recapitalization Bonds amounting to a total of ₹135,000 crore. Public Sector Banks (PSBs) may well be the only buyer of these bonds. (When you BUY a bond, you LEND your money to the borrower. The government would be the borrower here). The government would use the amount received from banks to buy equity stake in the same banks. Strange. Borrowing money from a company to buy equity stake in the same company.* Corporate finance course dies a slow death*
- Government would channelize funds of ₹18,000 crore from its budget to buy direct equity stake in public sector banks. This is simple.
- PSBs would raise the remaining ₹58,000 crore from the market themselves. Government would have infused enough capital in the banks by then. Banks ought to take care of themselves.
Recapitalization seems to be a messy affair. Why do we even need it?
*First year Macro Econ. Class comes to rescue, remembers the money multiplier phenomenon*
Banks work on the following regulated formula when it comes to taking lending decisions:
Amount of money allowed to be lent = Total Capital/Tier-1 Capital requirement ratio
(Tier-1 capital for bank comprises of Retained earnings, Common stocks, Provisions, etc.)
This essentially means that if a bank has ₹100 in capital, it can lend an amount up to ₹1000 (Assuming a 10% capital requirement). Now assume that our bank has ₹100 in capital and lends ₹1000 to a businessman. Unfortunately, the businessman is not in the best of financial conditions and the bank loses ₹50. (By creating provision for bad debt) The loss of ₹50 would be reflected in the reduction of bank’s retained earnings. With only ₹50 left as capital now, the bank cannot sustain a Net outstanding loan of ₹950 as per the norms. Bank either has to raise capital of further ₹45 or call-in the outstanding loan. The latter is usually not possible, leaving banks with only one option to capitalize further if it has to meet the norms.
If the government were to step in and provide the bank with ₹45 as additional capital, the bank would meet the norms and can think of lending further. With big uncertainty over government’s ability to recapitalize the banks, banks are unwilling to book losses (Provide for NPAs in the financial statements). Taking the previous example, our bank would keep on restructuring the previous loan of ₹1000 so as to avoid taking the hit of ₹50 on capital, further aggravating the problem. If the government provides ₹50 to the bank as capital, it can take the hit as the capital ratio becomes 100/950, meeting the requirements. They even have the ability to lend ₹50 further.
Summarizing, Indian PSBs need recapitalization. In absence of that, they would be hesitant to book further losses and lose the ability to provide further credit. Reducing the capitalization ratio is not an option as the banks across the world follow standard Basel norms and they are only going to tighten going ahead.
Doesn’t this hint towards a government bailing out of Indian PSBs?
It surely does. There are hardly any comments on what next after the recapitalization from the government.
The story shouldn’t end with government recapitalizing the banks and banks in turn becoming audacious enough to recognize their losses and lend further. Yes, the losses have to get recognized on the books. But the banks can still try to get the most out of the defaulting companies. The Bankruptcy law can be of great help when banks start liquidating the assets. All that is recovered will add to the capital by way of increase in Net profits.
Any other options that the government could have explored?
Not as many as the Indian ODI team currently has for the no.4 batsman. Only another viable option seems to be the privatization of the PSU banks, which would have required some capital infusion anyway on top of the political trouble for the government.
Seems quite a clean-up. What are the implications for the Indian economy?
With a clean-up of this scale, there are bound to be several side effects. With banks finally freeing up to lend more to the private sector, there will be more liquidity in the market. This can result in inflation at least in the short horizon. RBI might eventually have to increase the interest rates, ending the low-interest-rate cycle. This is not necessarily a bad thing as the growth would be driven by more sustainable factors such as private investment and consumer spending.
At the same time, this mega recapitalization is likely to raise some eyebrows from the credit rating agencies. The capitalization would push up the debt levels and subsequently the Debt to GDP ratio. Higher debt levels of the government often result in higher yields in the bond market.
What about the government deficits? Wouldn’t higher debts worsen the fiscal deficit numbers?
This is where the financial engineering really comes in. IMF is completely cool with calling the plan a cash neutral one. (Which is true as the Banks are lending money to the government, which in turn is investing in the banks) The only additional line item is the interest payment on the bonds. The interest components do increase the fiscal burden by ~0.8% of GDP, but may very well be offset by the positive sentiment which spurs investment in the economy.
Well played, GoI!
All said Recapitalization can act as an external steroid for an economy which was resembling Rohit Sharma of yesteryears- promising, capable but somehow failing to deliver.
The path ahead
The recapitalization plan, like most other Government announcements, has created a buzz in India. PSU Bank stocks are rising like Virat Kohli’s century count. However clichéd as it sounds, the path ahead becomes extremely crucial. The recapitalization plan needs to be followed by Bank reforms. Otherwise, the banks, flushed with fresh capital, would again start lending poorly, the classic ‘moral hazard’ phenomenon playing on the part of banks.
There are myriad structural issues in the banking system which includes but are not limited to poor lending decisions, misaligned incentive structure for top managers and lack of legal and project evaluation expertise. Without addressing these issues, it might turn out that the government is just providing a bandage when surgery is required.
From removing money to adding money, we have seen it all. Removal didn’t quite remove what it intended to remove, I am still banking on the addition to add what it intends to add: Credit growth, Private Investment, and the GDP!
Written by Nishant Shah
Nishant is a PGP student at IIM Ahmedabad.