The Bank Recapitalisation Bond- Explained


Recapitalisation bond

In an announcement made on 24th October 2017, the Government decided to infuse Rs. 2.11 lakh crore capital into the public sector banks (PSBs) over the next 2 years.

Since the Government is the majority shareholder in the public sector banks, it has to provide equity capital if the banks are struggling. This injection of capital is also known as the recapitalisation of banks.

The recapitalisation is aimed at tackling the twin balance sheet problem in India and also to revive growth and investment. (Read: Twin Balance Sheet Challenge Explained)

The Non-Performing Assets (NPAs) in the banking sector have been rising. As of June 2017, the NPAs of the banking system were as high as 10.2 % of the loans advanced by the banks. This high NPA has limited the capacity of banks to lend. The bank credit growth in the year 2016-17 was 5.1 %, which is the lowest since 1951. (1) Hence, a massive recapitalization was deemed as necessary to clean up the balance sheet of the banks.

The recapitalization of banks worth 2.11 lakh crores has been proposed to be done in three ways:

  • Budgetary allocations: 18000 crore
  • Raised from the market through the issue of equity shares by banks: 58000 crore
  • Issue of Recapitalisation bonds by the Government: 1.35 lakh crore
Budgetary allocations

In this year’s budget, the Government had already allocated Rs.70000 crore for recapitalisation until 2019. Out of this, Rs.50000 crore has been provided to the banks. In his budget speech, the finance minister, Arun Jaitley had stated – “additional allocations will be provided as may be required”.

As per the recent announcement, Rs.18000 crore will be released out of the present allocations.

Issue of equity shares by banks

Banks were already expected to raise Rs. 1.1 lakh crore from the market through the issue of equity shares, under the Indradhanush scheme. But, banks have raised only 21000 crores till now. As per the recent announcement, additional 58000 crores will be raised from the market.

Some analysts have questioned the ability of the banks to raise funds from the market, given the fact that they have raised only a fraction of the amount expected by the existing Indradhanush scheme.

Recapitalisation bond

The Government will issue recapitalisation bonds worth Rs.1.35 lakh crores. The structure of the bonds has not been worked out by the finance ministry yet. But, it is expected that the bonds will be bought by the banks themselves.

After demonetisation, the banking sector is flush with liquidity. It will use this excess liquidity to buy recapitalisation bonds from the Government. The Government will then use the money raised through issue of bonds, to buy equity shares in the banks.

In effect, the recapitalisation bonds will be exchanged for equity shares.

This is not the first time that the bank recapitalisation bond will be issued in India. According to the data by Bloomberg, in the year 1994, India had sold about 48 billion rupees of 12-year recapitalisation bonds at a coupon rate of 10 % (2).

Some commentators are worried about the impact of recapitalisation on fiscal deficit of India. However, under standard international accounting practices, recapitalisation bonds are classified as ‘below the line’ financing and not included in the fiscal deficit. Hence, it will not increase fiscal deficit.

But, under the accounting practices used by India, recapitalisation bonds are added to the fiscal deficit calculations. However, when recapitalisation bonds were issued in the 1990s, they were not included in fiscal deficit calculations. The Government had classified them as off-balance sheet items. (3)

Either way, the yearly interest payments on the bonds issued will be included in the fiscal deficit. But, its impact will be marginal. The chief economic advisor of India, Arvind Subramaniam, estimates the interest payments to be around 8000 to 9000 crore per year.

The massive recapitalisation will strengthen the capital base of the banks. It will help banks to write-off its bad loans and subsequently increase its lending capacity. (Read: Loan Write off is not a Waiver )

According to Goldman Sachs, it could boost credit growth by up to 10 %. An important caveat is, there should be a demand for credit too, for an increase in credit growth to take place. (Read: Why is India’s growth slowing down?)

The stock markets reacted positively to the news. The day after the announcement, 25th Oct 2017, was a historic day for the markets as the SENSEX closed beyond 33,000 for the first time ever. An index of Public Sector Banks surged 30 % on the day.

All said and done, recapitalisation is only  the first step to address the rot in the banking sector. The Government should follow it up with structural reforms to reduce its role in the public sector banks and move towards privatisation. This will bring in efficiency and accountability.

The capital infusion will address the problem of stock of NPAs by cleaning up the balance sheet. It is equally important to ensure that the cycle of piling up of NPAs is not repeated.

To conclude, the capital will help the banks to comply with Basel 3 norms that will come into force in 2018. Some analysts have estimated that banks need an even larger infusion to comply with BASEL 3.

For the uninitiated:

A bond is an instrument issued to borrow money. Hence, a yearly interest has to paid on the face value of the bond and the face value is itself repaid after the maturity of the bond. In this particular case, the Government is the issuer (borrower) and the bank is the buyer (lender).

BASEL-3 norms are the international banking regulations that have to followed by the banks in all countries. According to it, the banks have to maintain a capital-adequacy ratio of at least 8 %.

The capital-adequacy ratio is the ratio of capital to the risk-weighted assets (loans etc) of the banks.  Hence, more capital is required to be able to give more loans.

If you like this article, please share and comment.

References:

  1. An article in the Hindu business line
  2. An article in Livemint

Have any Question or Comment?

3 comments on “The Bank Recapitalisation Bond- Explained

praveen kumar

can you elaborate on how money will be pumped in by bonds ? goverment will issue bonds (based on what ?? )and banks will buy them with their excess liquidity and how govt buys equity shares and how will it improve health of bank ?? its their money which is coming back ??I’m unable to understand mam

Reply
Mridusmita

The Government will issue bonds to take loans from the public sector banks. It will be shown in the asset side of the bank’s balance sheet.

The amount raised will be injected as capital into the banks. It will be shown in the liabilities side of the bank’s balance sheet as equity capital. As far as liquidity is concerned, it will have no effect on banks.

Visualise the balance sheet of a bank. On the liabilities side, they have equity capital provided by the owners (Government in case of PSBs) and deposits made by the people. On the asset side, they have loans made to people. Some loans are on the verge of default and are classified as Non-performing Assets. Banks have to set aside some amount from their profits as provisions to provide for these potential losses. As a result, the capital base is eroded.
Also, the banks have to maintain a minimum amount of capital as a percentage of risk-weighted assets (loans etc.) as part of BASEL norms. Hence, the NPA crisis and the minimum capital requirement by BASEL has limited the lending ability of the banks. The recapitalisation is meant to clean-up the balance sheet of the banks.

Hope it helps. Keep reading and sharing.

Reply
Mridusmita

One more thing, the banks have to maintain a minimum amount of capital as a percentage of their risk-weighted assets (loans etc). They have to maintain more capital for riskier assets. But, recapitalisation bonds (loan to Government) are risk-free and will not require additional capital. Hence, all the capital infused through bonds can be used to provision for NPAs and to maintain a healthy capital adequacy ratio.

Reply

Leave a Reply

Your email address will not be published. Required fields are marked *

Subscribe to Economyria by Email

Please enter your email address:

Subscribe to Economyria’s Feed