How About Boosting Banks With Issue of Recapitalization Bonds?

As Indian PSU banks face the big challenge of expanding their asset books without expanding the NPAs, the question of bank capital is back again. If Indian banks are to adhere to the Basel III norms by 2019, they will require billions of dollars in capital. The question is; where will the money come from? There are limits to the government recapitalizing the banks as it will lead to a sharp increase in the fiscal deficit. The government has maintained a strict focus on fiscal discipline in the last few years and they will not want to concede that advantage. The alternative is for banks to raise money on the strength of their own balance sheets. That is more of a theoretical possibility as no PSU bank is likely to get even a reasonable valuation at this point of time; leave alone an attractive valuation.

Linkage between capital, NPAs and loan haircuts…

The RBI has already initiated the NPA control in two ways. Firstly, they have identified banks that are extremely stressed and there are severe restrictions and controls on these banks. The RBI is also exploring the possibility of merging stressed banks with stronger banks or look at an outright sale. Secondly, the RBI has also initiated the crucial proceedings against errant companies under the Insolvency and Bankruptcy Code (IBC). The 12 major defaulters have been given a maximum of 180 days (extendable to 270 days) to come up with a resolution plan, failing which the RBI will initiate insolvency proceedings against the said company.

Now that is exactly where the dilemma for banks begins. Most defaulting companies are asking for haircuts between 40-50% to amicably resolve the problem. But to offer such haircuts, the banks will require billions of dollars in capital, which they currently do not have. This really puts the Indian banks in a catch-22 situation. They have NPAs to the tune of $90 billion and stressed assets for an equal amount. That is hardly a sustainable scenario without a massive infusion of capital. As a recent report had rightly noted; the combined NPAs of the Indian banking system has now exceeded the net worth of all the banks put together. One answer to this challenge will be to issue recapitalization bonds…

What exactly are recapitalization bonds?

Let us first understand how the concept of recapitalization bonds will fit in. Most Indian banks are sitting on a mountain of liquidity. When the demonetization exercise was undertaken in November last year, people with old notes were perforce required to surrender all their old notes through the banking system. This led to the banks getting surplus liquidity to the tune of Rs. 4 trillion which was largely responsible for call rates becoming tepid. However, there was no commensurate demand for credit as most corporates with a good credit rating managed to raise funds in the bond market at much lower yields. The result was that banks ended up investing most of this liquidity in government securities resulting in the Statutory Liquidity Ratio (SLR) bond holdings of banks exceeding the minimum requirement by up to 700 basis points. This combination of a surfeit of liquidity and weak credit demand can be used to design a recapitalization bond to address the capital problem.

How will the recapitalization bond idea work?

Since the banks are anyways sitting on surplus liquidity and investing in G-Secs, recapitalization bonds can be used to convert the bank liquidity to actually recapitalize the banks. Firstly, the government of India, through the RBI, will issue Recapitalization Bonds. Banks, who are sitting on surplus liquidity, will use their resources to invest in these recapitalization bonds. With the funds raised by the government through the issue of recapitalization bonds, the government will infuse capital into the stressed banks. This way, the surplus liquidity of the banks will be used more effectively and in the process the banks will also be better capitalized and now become capable of expanding their asset books as well as negotiating with stressed clients for haircuts. Recapitalization bonds are nothing new and have been used by the RBI in the past. In fact, the former RBI governor, Dr. Y V Reddy, continues to be one of the major proponents of recapitalization bonds in the current juncture. More so, considering that the capital adequacy ratio of Indian banks could dip as low as 11% by March 2018 if the macroeconomic conditions worsen.

Are there risks to the issue of recapitalization bonds?

Technically, in the current context, there is really not much of a risk in issuing recapitalization bonds. The outside risk of recapitalization bonds is that this move may tighten liquidity in the system if all the surplus liquidity in the banking system goes into its capital. However, since recapitalization bonds are callable in nature, this risk should not be too great. Also, the debt markets are now sufficiently deep and broad and can support the funding needs of the India corporates and hence that is unlikely to be a major issue. The only concern is that rating agencies globally will look at recapitalization as a form of off-balance sheet financing, which does not give them too much comfort. Many rating agencies look at such bonds as a means of raising debt that is not visible in the fiscal deficit.

But recapitalization bonds may still be the best option for now…

Alternatively, the government can look to postpone its adherence to Basel III from 2019. But that will be seen by global markets as an admission by the government of India that it does not have the liquidity to capitalize its banks. That may not go down well with foreign investors. Under these circumstances, infusing capital into the banks through the issue of recapitalization bonds may be the best option available!