Using recapitalization bonds to boost bank’s capital…

Indian banks and the RBI are currently finding themselves in a tight situation. To begin with, Indian banks are sitting on a pile of bad debts. According to conservative estimates, the NPAs of the banking system are to the tune of $90 billion and if the stressed assets including the CDR assets and other restructured assets are added up then it comes up to nearly $180 billion.

But why is it a Catch-22 situation? The only answer to the NPA problem is to resolve the bad loans through a massive provision. But to make a large provision, banks need a very comfortable capital base, which they currently do not have. In fact, the total stressed assets have already exceeded the total capital base of the Indian banks overall. If you just look at the PSU banks, the situation will be much worse. So what is the way out? The answer could be by issuing Recapitalization Bonds.

How exactly will recapitalization bonds work?

  • To understand the logic of recapitalization bonds it is first essential to understand the macroeconomic environment first. Indian banks are having a surfeit of deposits but weak credit demand.
  • How was the massive mountain of deposits created? That is largely an outcome of demonetization that the government of India undertook in November 2016. Since all the notes of 500 and 1000 denominations had to be necessarily routed through the banks, this resulted in a massive rise in bank deposits.
  • According to conservative estimates, the demonetization resulted in Indian banks getting deposit accretion of nearly Rs.400,000 crore. Most of the money that was lying in cash had to perforce come out of the vaults of the people into their bank accounts. This resulted in this surfeit of deposits with the banking system.
  • This forced many banks to cut their lending rates sharply as they did not want a situation where they were paying interest on the deposits but were not earning yield on their funds due to weak credit demand. It led to a situation where the banks had to cut lending rates by as much as 90 basis points. Despite these rate cuts, credit growth has remained at a 20-year low.
  • On the other hand, bank NPAs were piling up predominantly from their exposure to sectors like steel, infrastructure, textiles, infrastructure and power. With credit demand unwilling to pick up the NPA situation only worsened and the profits continued to take a hit. At the same time, banks were getting grossly undercapitalized and needed to urgently shore up their capital base.
  • There are typically two ways to shore up the capital base of banks. The first is to issue fresh equity and raise money either through an IPO or through private placements. The challenge is that with the current state of financials, banks will not be able to get attractive valuations. Most institutions are unlikely to show keen interest in NPA-ridden banks. And fresh issue of shares will mean that the equity of these banks will get further diluted.
  • It is in this situation that Recapitalization Bonds come in handy. Banks are sitting on a mountain of bad debts and they need more capital to shore up their balance sheets and take write-offs. At the same time, the same banks are sitting on a huge pile of deposits but do not see adequate demand for industrial credit. This puzzle can be resolved by recapitalization bonds.
  • As a first step, the recapitalization bonds will be issued by the government specifically for the purpose of shoring up the capital of banks. The same banks who are sitting on a pile of deposits will now invest in these recapitalization bonds issued by the government of India. Since banks are already holding excess SLR securities to the tune of 700-800 basis points, they have plenty of liquidity to spare.
  • The government then uses the funds so raised to infuse into the capital of banks. This hits two birds with one stone. On the one hand, the bank is able to utilize its deposit base more productively. By converting them into capitalization bonds they are effectively moving the funds from the liabilities side of the balance sheet to the assets side and then back to the liabilities side as infused capital.
  • One can argue that it is merely an accounting entry, but then it solves the problem nevertheless. Recapitalization bonds are nothing new and have been used by the Indian government in the past. In fact, former RBI governor Dr. Y V Reddy has clearly spoken out in favour of the government issuing recapitalization bonds, albeit temporarily.
  • While the concept appears to be technically quite sophisticated and acceptable, there are 2 major objections to recapitalization bonds that are normally raised. Firstly, the concern is that if there is a spurt in credit demand then banks may not be in a position to build their loan banks at short notice as most of their liquidity will be locked in recapitalization bonds.
  • There is also a larger issue of moral hazard in recapitalization bonds. The worry is that it may force the government to look for quick-fix solutions rather than attacking the root of the problem. In the past, rating agencies have been uncomfortable of similar oil bonds issued by the government as they saw it as a form of off-balance sheet financing by the government.
  • The crux of this debate is that the Indian banks will have to adhere to Basel III norms by 2019 and there is no other way of reaching the capital adequacy target by then. Of course, India can ask for more time to adhere to Basel III, but that may not go down well with global investors.

In the short to medium term, Recapitalization bonds seem to be the answer. It can actually hit two birds with one stone.

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