Recapitalisation of public sector banks, and financial repression
- 06 November, 2017
Public sector banks (PSBs) in India have incurred huge losses over the years. These losses have been eroding the equity capital of PSBs. On 24 October 2017, the Government of India (GOI) announced
The letter and spirit of Basel capital adequacy norms
After the announced scheme is implemented, R-bonds will become assets of PSBs and the (additional) equity capital will be on the liabilities side of the balance sheets of PSBs. So, the GOI will effectively be investing in
While the GOI is indeed observing the letter of the Basel capital adequacy norms, it is violating the spirit of the international banking regulation. The true norm or the intended norm is that equity capital of a bank should be raised from the shareholders from the latter’s own funds. This is not to say that the shareholders cannot borrow the funds if they have a cash constraint at the time they invest in equity capital. They can indeed borrow but the borrowing should not be from the very banks whose equity capital they are investing in! However, the GOI will not be following this norm, given the announced scheme of recapitalisation. What exactly is wrong in this case?
Under the announced scheme, the PSBs will hold the R-bonds for a while, if not for the entire duration of the bonds (the details of R-bonds have not been spelt out yet). There is a question mark on the quality of the assets (the R-bonds) that the PSBs will hold. This is because the R-bonds will be issued by the GOI or a government-sponsored special purpose vehicle (SPV). Now, the ratings of the GOI bonds are quite low; the rating by the international rating agency, Moody’s is Baa3 positive as on 19 October 2017. So, the GOI bonds are risky. This somewhat negates the strengthening of the banks’ balance sheets due to the recapitalisation of PSBs (Singh 2012).
Such negation of Basel capital adequacy norms would not have happened if the GOI had decided to raise funds through normal or usual bonds, and used the funds raised to recapitalise PSBs. The reason is simple. The PSBs would not have been saddled with additional risky GOI bonds1.
More on the risk in GOI bonds
Besides the low ratings of GOI bonds, there are other facts as well that support the view that GOI bonds are risky. Typically, the focus of the media and even many academic economists is on measures like the ratio of deficit to GDP (gross domestic product); the GOI is targeting fiscal deficit at 3.2% of GDP. This ratio is not high but if the deficit of the states is also considered, then the combined fiscal deficit is indeed quite high at 6-7%. But even if we consider the GOI alone, there is an important concern; this is about the use of an appropriate metric to gauge the fiscal situation. Reinhart and Rogoff (2009) have suggested the use of the ratio of deficit to taxes; the reason is that the ability of the GOI to redeem or roll-over its debt depends on its own income (taxes) rather than the income of the whole country (GDP). It is interesting that the fiscal deficit is a whopping 26.52% of the total receipts of the GOI2. Therefore, the fiscal situation is not good in India.
The nominal interest rate on 10-year GOI bonds is 6.808% as on 27 October 2017. Given RBI’s pre-announced inflation target of 4%, we may view the real interest rate at 2.808%. This includes, broadly speaking, the pure interest and the risk premium. This may suggest that the risk premium is not high and the GOI bonds are quite safe. However, the yields on government bonds in India are determined in a market where the participants (like banks and important insurance firms) are required to observe statutory liquidity ratio (SLR) and other such formal or informal diktats of the GOI (the SLR is 19.5% of demand and time liabilities of banks); this creates a captive demand for government bonds in India. Given this (forced) demand, the prices of bonds are high and accordingly the yields on such bonds are low compared to what these would have been in a truly free market. Hence, notwithstanding the reasonable yields on such bonds, the GOI bonds are, in fact, intrinsically risky.
Mitigating the risk in GOI bonds
The fact that GOI bonds are risky has an interesting implication. The PSBs will be, as mentioned earlier, holding more of such risky assets on their balance sheets after the announced scheme of recapitalisation of PSBs is implemented. So, there is an issue of risk and financial instability in the banking sector now (the PSBs still have about 70% of the deposits). This is rooted in the risk in GOI bonds. Can this risk be somehow mitigated?
We have already seen that the GOI formally or informally requires banks and many other financial institutions to buy and to continue to hold such bonds in which case, the GOI will not face a fiscal crisis – notwithstanding the intrinsic risk in the GOI bonds. If the GOI is most unlikely to face a fiscal crisis, then it is very interesting that the GOI bonds may be viewed as safe assets for banks! This, in turn, implies that there is hardly any issue of banking crisis related to banks’ holdings of government bonds.
No free lunch
The possible banking instability related to banks’ holding of (intrinsically risky) government bonds may, in practice, be avoided but this comes at a cost. If banks are required to hold GOI bonds, then the bank credit is adversely affected. This affects the real economy. This is a real cost that the economy incurs for ensuring banking stability despite the use of intrinsically risky government bonds on balance sheets of banks (Singh 2013). We are familiar with this in the economics literature as the cost of financial repression in the economy
Given the need to finance Rs. 1.35 trillion of bank capital in PSBs, the choice for the GOI was between using R-bonds and normal bonds. The GOI chose R-bonds (this way, it does not show up as
It is true that the issue of normal GOI bonds (instead of R-bonds) would not have avoided the risk that is inherent in GOI bonds but at least the cost of this risk would not shift to the PSBs. It is also true that with normal GOI bonds, the fiscal deficit as measured by the IMF would have gone up but the substantive adverse effects on the economy at home would have been less.
The cost of (additional) financial repression may not be large at present, given the possibility that the low credit growth is to some extent a demand-side problem rather than a supply-side issue related to equity capital which had been, over time, getting eroded in PSBs. However, the R-bonds are very likely to be long-term bonds and the PSBs will be expected to retain these bonds for a while before they can possibly sell these in the market. When the PSBs want to sell the R-bonds but they cannot, that is when the cost of (additional) financial repression will bite more than it does at present.
1. Y.V. Reddy (former Governor of the Reserve Bank of India (RBI)) and many others often argue that the PSBs are government-backed banks and so the question of unsafe PSBs does not arise in the first place (https://www.bloombergquint.com/opinion/2017/07/13/are-recapitalisation-bonds-the-no-brainer-solution-to-indias-bank-capital-woes). This is true. 2. However, observe that if the PSBs are, in practice, immune to bankruptcy, this can only be because the GOI stands ready to bail them out sooner or later after their losses pile up.
The fiscal deficit for the GOI for 2016-17 as per the revised estimates is Rs. 5,342.74 billion (http://indiabudget.nic.in/ub2017-18/bag/bag2.pdf). The total receipts (revenue receipts plus the capital receipts) for the GOI are Rs. 20,144.07 billion (http://indiabudget.nic.in/ub2017-18/bag/bag1.pdf ).
Mohan, R (2011), Growth with financial stability – Central banking in an emerging economy, Oxford Collected Essays, Oxford University Press, Delhi.
Reinhart, CM and KS Rogoff (2009), This Time is Different; Eight
Singh, G (2012), ‘Seemingly safe banks in an emerging economy’, 6th Annual Conference on Growth and Development, Indian Statistical Institute, Delhi Centre, 18 December 2010.
Singh, Gurbachan (2013), “Is India hedged against systemic risk? An attempt at an answer”, Review of Market Integration, 5(1):83-129.
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