Banks capital has to rise in keeping with the rise in its business. Capital should happen as banks receive more deposits, their loans (which are their assets) rise and overall business increase. Banks have to do this to maintain their capital to assets ratio, as a safety norm. Bank for International Settlement (BIS) has routinely given capital requirement ratios.

But the current talk on the urgency of raising capital of Indian banks has a different orientation. This is the second aspect of the issue. As the non-performing assets of banks increased recently and banks were directed by the Reserve bank of India to recognise their bad loans their capital base got eroded. This called for immediate capital replenishment. It is directly this related to the issue of non-performing assets of Indian banks and how the banks are going to resolve this.

The dilemma over capital replenishment stemming from erosion of capital from bad debts is not unique to India. This has happened before and could safely be predicted should happen in future. So there are models for handling this already.

The most celebrated of these episodes of bank capital erosion was as recently as in 2008 when the Holy Grails of global banking were contaminated with bad loans. Largest of US banks were facing the prospects of liquidation as their assets portfolios simply evaporate in the aftermath of the financial melt-down. The detection of the toxic assets, the so-called derivative products in the portfolio of the US banks, made clear that most of their capital were being wiped out. The options were two-fold: either face liquidation and close down. This happened to one of the greatest institutions of US financial world: Lehmann Brothers.

It was as an afterthought following the collapse of Lehmann, that the US government decided to step in and pumped hundreds of billions of dollars in capital in the beleaguered banks. The home of high capitalism, which abhorred government interfering in private sector corporations, the decision to allow US government funding of banks raised questions of “Moral Hazard” and basic principles. But this was done to save the financial system. The troubled banks were thought to be too large to be allowed to fail.

Similarly, earlier Japanese banks had also faced a similar dilemma when the big banks in that country had put large funds into realty companies and the property prices slumped. To safeguard their interests and stay away from declaring their property loans to be bad, the banks kept on funding the companies in trouble and thus acquired more of the doubtful debts. This had given rise to what has been termed by monetary economists as “misallocation of credit.”

Misallocation of credit because instead of giving their funds to more productive and profitable sectors, the banks continued to fund the unviable and uneconomic property companies to save themselves from bankruptcy. Obviously, the process could not have gone on and the financial authorities had to step in.

But in Japan’s case, the entire operation was rather kept under the wraps and bank recapitalisation was done surreptitiously. The fear was that open admission of the extent of the trouble would result in complete erosion of confidence in the financial system and thus will have serious repercussions. Thus, banks were given funds in small tranches and after long delays. That had defeated the entire purpose of the entire operation.

In our case, the issue of bad loans have been known for ever. But the pitch was rather queered by the former governor of the Reserve Bank, Raghuram Rajan. Until then, while it was often admitted that banks have bad debts, open admission of the huge and debilitating impact of the issue was not publicly admitted. In a speech now considered a landmark, he had hinted that unless the problem is fully recognised and provisions made, this had the potential of resulting in a major financial sector collapse, so to say.

Ever since, we are talking about humongous amount of bank recapitalisation needs. Government is committed to put more than Rs1.3 lakh crore into the public sector banks as fresh funds out of Rs2.5 lkah crore which is estimated to be required in the medium term. Various alternatives are being evaluated including issue of recapitalisation bonds. Some had also suggested using part of the foreign exchange reserves for shoring up bank capital.

Large budgetary support for recapitalisation cannot be reasonably expected as that could upset the fiscal arithmetic. There are other constraints like minimum holding norms for government. That means that the banks cannot make public offers indiscriminately as government holding cannot be diluted to less than 52%. But there is no doubt that the funds requirements are massive.

Some global rating agencies estimate the recapitalisation requirements of Indian banks to be around Rs5 lakh crore. However, this could at best be estimates because the trend in bad loans accumulation, resolution of some of the bad loans through process of debt restructuring and turn around in the economy could have critical impact.

Even then, recapitalisation is not such an insurmountable matter. Funds could be raised in various combinations and with flexibility and a clear roadmap can be drawn up. The issue is that the episode of bad debts and subsequent capital erosion must stop. We cannot afford to have a relapse. Institutional and severe penal mechanism should be in place to ensure that.

It has been now at least identified that a handful of big defaulters account for a quarter of the toal bad loans. The RBI has now set in place an elaborate mechanism for resolving the bad loans, which the banks boards and managements had earlier refrained from doing. Additionally the starting of operation of the bankruptcy code and the trigger to bankruptcy proceedings have also made a huge difference. Because of these developments, now it is no longer possible for promoters of defaulting companies to sit tight over bank money. They also have to be active as otherwise they would lose control of their companies.

Hopefully, with the current emphasis on resolving this and the preventive mechanism now in place, it should be possible to overcome the intertwined twin-problem of capital erosion from bad loans of public sector banks. (IPA Service)