Focus on bank functioning MARKET INSIGHT

Reforms might be difficult due to elections and hostile bank unions

The proposed recapitalisation of public sector banks is at centrestage. We’re lacking details beyond the fact that the government intends to pump ~2.1 lakh crore into recapitalisation of the banks that it owns over the next two years.

This may not be enough. Market estimates indicate public sector banks (PSBs) will need over ~4 lakh crore of Tier-1 recapitalisation to meet Basel-III norms for net worth, after provisioning for non-performing assets (NPAs). They may need more. This estimate assumes a reasonable percentage of NPA recovery. Cases have been initiated under the new bankruptcy law but recovery has been at huge discounts, over 90 per cent in at least one case.

The recap method is interesting. First, the government will subscribe something over ~18,000 crore to PSB equity under an earlier Budget commitment. The banks will issue fresh equity of another ~58,000 crore to be sold in market transactions, or strategic deals.

The remaining ~1.35 lakh crore will be generated through a complex process. The government will issue recapitalisation bonds. Banks will buy those bonds. The Government of India (GoI) will use the money received to subscribe to fresh equity in PSBs. This way, ~1.35 lakh crore is transferred from deposits held by banks (a liability) to GoI loans (an asset) and returned to the banks as equity (Tier-1 Capital). The banks will continue to hold those bonds, of course.

So the GoI is committing ~18,000 crore of its own funds to the recapitalisation, while hoping that the market will subscribe ~58,000 crore. It is cleverly creating ~1.35 lakh crore by shifting cash around from one part of the balance sheet to another.

It’s unclear what banks will be allowed to do with the bonds. The tenures, interest rates, other terms, of these instruments are all unknown. But by definition, there is a sovereign guarantee. So there will be takers if these can be sold on. This way, the GoI increases its already large equity stakes in these institutions. The NPA problem is kicked some way down the road. The recapitalised PSBs will then be capable of expanding loan books.

The market obviously likes this plan, at first glance. But the devil is in the unknown details. Here are some possible consequences.

The government takes on some extra debt. Whether this debt technically counts towards the fiscal deficit is debateable. But there will be some interest outflow. If PSU banking stabilises, the GoI may be able to sell off some stake at higher valuations, while retaining tight control.

PSBs are not fully recapitalised and will have to raise more money. One way is to resell the bonds in the secondary market. That will mean buyers diverting money from other investment options. A crowding out will happen and bond yields will rise. There will also be some crowding out in the primary market. This ~58,000 crore worth of PSB shares is nearly 2x of all initial public offering proceeds of the past nine months.

Given this respite, PSBs may continue making loans guaranteed to go sour in future. They have neither the incentive nor the autonomy to ensure loans are made on commercially sound lines. Moreover, PSBs will continue to be forced to bear the brunt of farm loan waivers. Large corporates with political connections will continue to treat loans in cavalier fashion.

The surge in PSB share prices has come before ‘Mr Market’ knows the details of financial engineering and can judge what's going on. This process will unfold through 2018-19 with the political establishment in continuous election mode. That means more farm loan waivers, more subsidised electricity and large statues.

If this plan is to work, there must be major reforms in the functioning and autonomy of PSBs. Or else, this cycle of bankruptcy followed by bailouts will be repeated ad infinitum. We have no assurances that such reforms will happen, especially in election years, and in the teeth of hostile bank unions.

Wall Street regulars used to refer cynically to the ‘Greenspan Put’. Anytime America's financial sector was in trouble, the long-serving Federal Reserve chairman, Alan Greenspan, would mount a rescue operation. So Wall Street happily took greater, more exotic risks. When the Greenspan Put blew up, the subprime crisis developed. This recap plan might end up being called the Jaitley Put, unless it is accompanied, or better still preceded, by coherent and determined PSB reforms.