Recently a Finance Ministry-led panel recommended the merger of small public sector banks with larger ones, stressing the need for internationally significant sized banks and reducing the duplication in infrastructure and product offerings across the 27 public sector banks. The call for such consolidation is also driven by the government’s inability to pump capital into public sector banks.
Recapitalisation, in the context of public sector banks, refers to raising equity capital. State-owned banks have a lion's share — about three-fourths of the total bank lending in India.
To ensure the smooth flow of credit, it is essential that these banks are well-capitalised, with sufficient capital to meet the economy’s growing credit needs and to comply with regulatory requirements.
Capital infusion
Since the Government is the major shareholder in these banks, and till now reluctant to reduce its stake, it has been contributing substantially in terms of equity capital. This amount has typically been set aside from the Government's budgetary resources.
The Government has been infusing capital year after year, helping banks meet their capital and growth requirements. Between 2011 and 2014, it injected about ₹58,600 crore. But after infusing ₹14,000 crore in 2013-14, the government has been tight-fisted in 2014-15 and pumped in ₹6,990 crore.
In the 2015-16 Budget, the government has set aside a meagre ₹7000 crore for recapitalisation. Considering that public sector banks need about ₹2.4 lakh crore over the next four years by way of capital infusion, government’s frugal allocation is worrisome.
What gives?
The lackadaisical performance of state-owned banks and growing pile of stressed loans in recent times has brought recapitalisation into focus. While the slowing economy has certainly led to bad loans piling up, the clear lapse in prudential norms has aggravated the problem.
After the financial crisis of 2008, while private banks consolidated their balance sheets, public sector banks continued to lend aggressively to risky segments. In the last year, bad loan issues have worsened. But the real worry is the large amount of loans that were restructured on the pretext of extending a ‘lifeline’ to businesses.
Systemic risk
The combination of bad loans and restructured loans now exceeds 11 per cent of loans. In most cases, stressed assets are now nearly 100 per cent of the net worth of state-owned banks. If the economy continues to go slow for a few more quarters, large amount of restructured loans could turn bad and lead to systemic risk.
The more stringent Basel III norms were implemented from April 2013, increasing the capital requirement for banks. As per Basel III norms, banks need to maintain 6.5 per cent of Tier I capital. But many public sector banks are just about meeting the capital requirement. With 10-15 per cent of assets under stress, a delay in economic recovery can erode public sector bank earnings, eating into their capital.
Given the poor condition of state-owned banks, where will the additional capital come from? Weak market and investor appetite has made capital raising a tall task for public sector banks. Smaller banks, in particular, will find it more onerous to raise capital from the market. This means state-owned banks will continue to depend on the government for capital.
Aside from lower allocations, the government has adopted a new criterion in which the more efficient banks — ones that have delivered above average returns in the last three years — will be rewarded with additional capital. This is likely to leave many small banks in the lurch, given their abysmal performance.
This means inefficient banks will now have to put their house in order before expecting the government to lend a helping hand. In the near term, banks with very low capital ratios and weak asset quality will find it difficult to grow and meet their Basel III requirements. Central Bank, United Bank, IOB and Union Bank have Tier I capital of less than 8 per cent and have not received capital infusion in 2014-15.
Moral hazard
But the government’s tacit backing has always increased the moral hazard for public sector banks. It has also left minority shareholders short-changed. Most public sector banks are trading well below their book value.
Capital infused by the government at such abysmal valuations has eroded the book value of many of these public sector banks by almost 50 per cent in the past. So, while in the short term, inadequate capital can impede the growth of some of the smaller banks, in the long run, it is in the best interest of investors and depositors if the public sector banks learn to fend for themselves.
A radically new governance structure will help these banks compete productively, and reduce the repeated claims for capital support. The government’s intent to reduce its stake to 52 per cent and constitute an independent Bank Boards Bureau (BBB) may help public sector banks to materially improve their efficiency.