PSB recap: Now what?
For recapitalisation to be a momentous step, we must see further reform of the HR and governance structure of the public sector banks
The government managed a moment of shock and awe with the recently announced plan to recapitalise public sector banks (PSBs). The sheer size of the recap, at ~2,11,000 crore, to be disbursed within two years was unprecedented. The announcement was unexpected both in terms of timing and scale. The markets gave the move a big thumbs up, taking the PSB stocks up by 30-40 per cent in a matter of a few hours. Many global investment banks are now falling over themselves in rushing to upgrade the sector. Many analysts are calling this the second most significant reform of the Modi regime (after the goods and services tax), and are busy raising their estimates for GDP growth in FY19. Many feel we will now finally unclog the banking system of non-performing assets, allow a clearing price to be established for bad assets and purge the system of bad loans and unproductive assets. There are some who also feel that the one-way trade of being overweight on private sector banks and NBFCs, and short the public sector banks, positioning which had continued to generate outperformance for a decade, was now coming to an end. But first the details. The proposed recapitalisation was broken into three parts. ~18,000 crore from the Budget, ~58,000 crore to be raised as equity from the market and ~1,35,000 crore to be provided by the government as recapitalisation bonds. All within two years but with the majority of the capital front loaded in the next four quarters. The recap bonds were new and the step that excited the markets, the other two elements had been a part of the previous Indradhanush plan.
The markets were excited as the quantum of the recap seems credible. Most estimates of capital required by the PSUs was in the range of $25-35 billion, so at $32 billion the proposed recapitalisation should be enough. It will allow the PSBs to fully provide for their bad loans, meet Basel-III norms and selectively start growing again. Second, as an investor you are taught that when looking at distressed financials, always wait for the final recap to participate, don’t commit capital before. With this recapitalisation plan, you have the finality, many of the public banks will now finally be investible, for the first time in years.
The plan also creates minimal macroeconomic stress. It seems, the real cost will only be about ~9,000 crore (interest on the recap bonds). It will not have any real impact on the fiscal deficit, nor will it pressurise interest rates or have any impact on liquidity in the system. It will be financial engineering, with the government issuing bonds to the banks, and redeploying the proceeds to subscribe to banks equity. Even if simply accounting, it is enough to rebuild bank balance sheets. The only negative macro impact seems to be a rise in government debt. Neither the ratings agencies nor bond markets seem perturbed by this increased debt, and if they don’t care then it really does not matter.
Frankly, given how smoothly this has been accepted, even applauded by the markets, one wonders why the policymakers took so long to go down this road. The need for capital has been known for years, with the Economic Survey mentioning the twin balance sheet problem in 2014 itself. Why did it take almost four years for the government to act? I understand the moral hazard problem, but we cannot hold the entire banking system and economy hostage to the politics of being seen to bail out big business.
The surge in the share prices of the PSU banks (most up 30-40 per cent) was really the market being caught short. Positioning was entirely one-sided; everyone long the private banks and zero ownership of the public banks. Given the relative market capitalisation of the two sub-sectors even a slight shift in ownership towards the PSUs was enough to move prices disproportionately. From here on, prices should settle down, albeit at a new higher level to reflect the new reality of adequate capital and absence of tail risk.
Going forward, the next step investors are looking for is HR and governance reform. Will the PSU banks be allowed to pay market-based compensation? Will they be allowed to bring in external talent with specialised skills? Will we see more measures to ensure depoliticisation of decision-making? Greater autonomy to the boards and senior management, with no retrospective questioning of commercial decisions. These are the steps we need to see to make sure this capital infusion will not be repeated again. Without these reforms, it may simply be more public money going down a black hole. The government has promised more reforms, it must target these areas. Unlike some I do not think privatisation is a panacea; much more important are these reforms, with or without private ownership. With these reforms, the banks may still go up multifold; without them the trade is pretty much done for all absent the top few public banks.
Will this hurt the growth prospects for the private banks and NBFCs? This is the top-most question for many global investors.
Unlikely, as the reality remains that even after this recap. Most of the PSU banks (except the top twothree) will only generate an RoE of 6-8 per cent. They will not be able to support loan growth faster than this through organic means. More than enough growth runway left for the private sector, especially as the economy begins to accelerate. Even when they lend, the PSU banks will focus on large- and mid-sized corporate loans and mortgages — the simplest and most commoditised of asset products. One could see higher competition and an erosion of net interest margins in these areas but limited impact elsewhere. Unsecured retail, microfinance, affordable housing, micro and SME — the areas of greater yield and complexity — will remain the focus for the private players. The growth runway here remains immense. The ability of the PSUs to address these areas remains marginal. With limited macro impact on yields or liquidity, even the funding for private players seems relatively unaffected.
This is a major positive step forward by the government. It will help in unclogging the banking system and allow the resolution of bad assets. We should see a greater flow of credit into the economy. The process of balance sheet repair will accelerate. However, for this to be truly a momentous step, we must see further reform of the HR and governance structure of these banks. Without that we will once again come full circle. We need to break this vicious cycle once and for all.