PSU Bank Recap: Why The Strong Must Be Fed And The Weak Starved Of Capital

The cycle of economic revival is likely to begin one or two quarters down the line, once the teething troubles with the goods and services tax (GST) are ironed out. The negative effects of demonetisation are already receding, and will disappear altogether by the third quarter (October-December). But GST-related troubles can linger on even in this quarter.

This adjustment period should be used productively so that enabling conditions can be created for the revival to take hold immediately, when it happens.

It is obvious that there can be no economic revival without a rejuvenation of the investment cycle; there can be no investment boom without adequate credit to fuel it; and there can be no credit growth without a recapitalisation of banks after a resolution of their burgeoning bad debts problem. At last count, gross non-performing assets, or NPAs, of 38 significant Indian banks was close to Rs 830,000 crore as at the end of June 2017, according to CARE rating agency.

The virtuous cycle of revival thus needs banks to be recapitalised first so that they can start resolving NPAs by either recasting loans to projects that seem viable, or by writing off and taking “haircuts” in the rest.

The National Democratic Alliance government, worried over the continued downtrend in growth domestic product (GDP) growth, is now sold on the idea of a fiscal package, which includes a generous dose of funds for struggling banks. This is a good move, and the logical way to infuse capital in banks is not to give equally to all of them, or even give cash to those most in need. The government must give more to the strongest, less to the marginal cases, and nothing to those who can’t survive.

Fairness is not a virtue when we are talking of making Indian banking healthy. Those that deserve to die need compassionate euthanasia.

According to CARE, just five banks – State Bank of India (SBI), Bank of Baroda, Bank of India, IDBI Bank and Punjab National Bank (PNB) – accounted for nearly half of the gross bad loans (or 47.4 per cent) of Indian banks. Of these five, SBI can probably manage to raise capital through internal generation, selling stakes in non-bank subsidiaries (SBI Life just had its first IPO), trimming down costs by eliminating excess overheads (branches, staff, technology, ATMs) following the merger of its five subsidiaries, and, if needed, raising additional Tier-1 or Tier-2 capital from the markets.

Three others, Bank of Baroda, Bank of India and Punjab National Bank, could do with some infusions, assuming their managements are keen to expand equity. In any event, they can combine a small equity infusion from the government with an equivalent raising of capital from institutions or even the general public.

IDBI Bank, which has the worst possible gross bad loans ratio (over 24 per-cent of advances), clearly needs to be privatised. Unlike other banks, IDBI Bank was set up under the Companies Act and not the various bank nationalisation acts. This means it does not need legislation to sell majority ownership to private parties, including institutions and general investors. Apart from selling Air India, the privatisation of IDBI Bank will send a strong signal that the Narendra Modi government will now take bolder steps.

Another midi-bank, Indian Bank, has one of the lowest gross NPAs of 7.21 per cent, which means it can take care of its capital needs itself. The government, which holds 82 per cent in Indian Bank, can probably sell a big chunk and raise capital for other banks.

Seven other public sector banks – UCO Bank, United Bank, Indian Overseas Bank, Central Bank, Dena Bank, Bank of Maharashtra and Corporation Bank – had gross bad loans of over 15 per cent, and these are the real problem banks. The sensible thing to do is to offer some of them half the capital they need and ask them to get the rest of it from the market, even at low valuations. The worst among them – Indian Overseas, for example – should simply be asked to become narrow banks. This means they can keep their deposits, but discourage further growth in them, and restrict lending only to the retail sector. They should be barred from lending to large projects or risky sectors. They should be asked to sell some of their good assets at a premium to the stronger banks, and then focus staff efforts on resolving their bad loans. These banks can also be given interest-free loans to start reducing staff through voluntary separation schemes.

As for the rest, they can be given small amounts of capital and seek mergers or raise money from the markets.

What should not be done is to force mergers between strong and weak banks merely because the government wants to avoid spending money on recapitalising the weak. Even a strong bank like SBI, which recently completed the process of merging its subsidiaries with itself, has found that its NPAs have bloated from more benign levels to a massive Rs 188,000 crore, which is more than a fifth of the entire bad loans of the banking sector. While SBI is a safe bank to bet on, the reality is that these mergers will take at least one or two more years to pay off in terms of improved cost efficiencies and rationalisations of branches and ATMs.

The problems of the banking sector are acute. Dealing with them needs the government to ease its own fiscal consolidation roadmap. It is worth noting that fiscal consolidation has two sides to it: when growth falls, it is tougher to stick to fiscal deficit targets since revenues also fall. It is only when growth revives that revenues rise and expenditures can be modest and within fiscal prudence limits. Tightening the belt is not recommended for an economy starved of investments.

(The above article was first published in DB Post)