Bank recapitalisation: Another bad idea

Recapitalisations in the 1990s and the late 2000s created a moral hazard problem which encouraged banks to engage in riskier lending knowing the government would bail them out if those loans failed.

WrittenBy:Dr Sanjiv Bhatia
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In the American sport of baseball if a batter whiffs the ball (called a strike) three times he is given out. For Narendra Modi and Arun Jaitley, after demonetisation and a poorly implemented GST, the recent decision to recapitalise government banks is strike three.


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There is an idiom that every student of Economics learns early: “Never throw good money after bad.” It refers to poor financial decisions people make of spending more money on something that they have already spent money on in an attempt to make it succeed, even though it is unlikely. The government’s decision to recapitalise state-owned banks using public funds is an excellent example of this.

Let’s first understand the problem so we can better grasp why the decision to recapitalise India’s failing state-owned banks is a bad decision.

Banks create money in an economy through the issuance of credit using a process called fractional-reserve banking. This is how it works: Say you deposit Rs 100 in your bank. The bank is required to hold only a small portion of the deposits as reserves and can loan out the rest. If the reserve requirement is 10 per cent, the bank can loan out 90 per cent of the deposit or Rs 90 in this case. The borrower then further deposits Rs 90 in her bank which too can now loan 90 per cent against this deposit or Rs 81, to another borrower. The Rs 81 deposited again creates another loan of Rs 72.9, and the cycle goes on.

So, with fractional-reserve banking, a single deposit of Rs 100 can create loans worth Rs 1000 (100 divided by 10 per cent). This process is hugely profitable for banks because they make interest on money created virtually out of thin air. In India, the reserve requirement is 5.75 per cent, so a Rs 100 deposit eventually becomes credit ( or new money) worth Rs 1,740 ( 100 divided by 5.75 per cent).

But like every other Ponzi scheme, this process works fine until some loans start defaulting. And this is what is currently happening in India. Almost 11 per cent of all loans outstanding are non-payable loans (NPLs). In other words, the borrowers cannot repay the principal or interest on these loans.

The money loaned by the bank is an asset on its balance sheet and when a loan turns bad the bank’s assets are reduced, which correspondingly also reduces the bank’s equity capital by the same amount. As a result, banks find themselves needing additional funds to meet their capital adequacy requirements.

Enter recapitalisation, whereby new equity is infused to increase the bank’s capital. In the case of a private bank, the existing shareholders would need to find additional sources of capital; otherwise, the bank will have to close shop. In free market economies, hundreds of banks fail as a result of bad loans and poor risk management. This is the creative-destruction process of free markets that enables efficient allocation of scarce resources — bad ideas lose out, and the resources invested in them get released and invested in good ideas.

But a public sector bank does not face this problem because it has access to public money which the government can inject directly, or it can avail of the government’s ability to raise capital by issuing bonds. The Indian government’s recapitalisation plan uses both Rs 18,000 crore of taxpayer money infused directly and Rs 1,35,000 crore raised by issuing bonds on which current taxpayers will pay interest, and future taxpayers will be stuck with repaying the principal amount on the bond.

What if, instead, of investing Rs. 2.1 lakh crore in trying to rescue bad banks that are likely to become worse in the future, the government sells its ownership interest in these banks to private investors and leaves it to them to handle the recapitalisation? Clearly, that would be the prudent and preferred option. But, privatising the banking system takes away a huge source of political power. Money is power and politicians never want to lose their control over money. How else would their crony capitalist friends, who fund the elections and the lifestyles of the political elite, get access to easy money?

Recapitalisation using public funds has been tried before. In the 1990s, the government put Rs 20,000 crore into public sector banks and in the years following the financial crisis another Rs 58,600 crore was injected. These recapitalisations did not improve these banks and instead created a moral hazard problem which encouraged these banks to engage in riskier lending practices knowing that the government would bail them out if those loans failed. Since the principal shareholder of public sector banks is the government, there is little market discipline imposed on their loan operations. The culmination of poor lending practices in a fractional-reserve lending system is now a full-blown banking crisis.

Some argue that since the government receives additional bank shares from recapitalisation, the potential to sell those shares at a higher price in the future is worth the risk. They cite the example of the US government that supposedly profited from its 2008 bailout of banks. But this is a ridiculous argument.

Firstly, recapitalisation involves issuing new shares which dilute the value of existing shareholders and has an adverse impact on the stock price.

Secondly, it is not the role of a government to engage in a speculative behaviour. If there is potential for profit, private investors will willingly buy shares of these banks, making it all the more attractive for the government to liquidate its holdings.

Thirdly, there are opportunity costs to be considered. The US government, for example, made a minuscule return of 0.6 per cent from its bailout of banks, much lower than the 3-4 per cent return it could have earned elsewhere. Would it not be more prudent for the Indian government to invest scarce public resources on much-needed infrastructure than to pour money into rescuing banks that have little chance of survival?

Fourthly, issuing bonds will add to the government’s debt and likely affect its credit rating and increase the cost of its borrowing that could wipe out any potential profit from the future sale of shares.

The government needs to understand that there are serious flaws in India’s banking and financial institutions which are at the source of this banking crisis, and instead of pouring billions into a flawed system they would be better advised to fix these institutional flaws.

Firstly, it is vital that India’s banking system be run with minimal government intervention. Privatising India’s banking system is an essential reform that must be undertaken immediately.

Secondly, India’s capital markets are in need of a major overhaul and modernization. Banks still dominate India’s lending structure providing almost 80 per cent of all the credit in the economy. In the US, nearly 70 per cent of private and public sector capital is raised using corporate and municipal bonds while bank lending is focused mainly on retail lending. Capital market credit is subject to market discipline, and its allocation is far more efficient than when done by a small group of bankers. India’s capital markets watchdog, SEBI, is a dinosaur that needs revamping (including its retrograde logo).

Thirdly, banks need to be able to diversify the risk from the lending process. Currently, banks take on the entire risk associated with loans because they have no opportunity to securitise the loans and pass the risk to other investors. In a securitisation, the loans are bundled together, repackaged, and sold as securities to investors in the capital markets. The Securitisation and Asset Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act of 2002 was designed for this purpose, but as with everything else in India, mindless government regulations and coercive tax laws prevent the growth of the securitisation market.

The details of Jaitley’s bank recapitalisation plan are still vague which suggests one of two things: either the government is unsure of how best to implement it, or, that they understand that recapitalisation is a bad idea and want to keep things vague so they can later punt on actually implementing it.

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