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Recapitalization Of Banks With Reforms: A Journey In The Right Direction

Let us first try to understand why the government is doing this? Why the government is wary of the systemic risk?


Once again the government, as expected, has announced the details of the recapitalization of banks to give relief to the banking sector from the burden of stressed assets. This is very well in line with what is commonly understood as ‘saving the bank against failure because of the fundamentalist approach of systemic risk in banks.’ In simple words, it means banks failing because of stressed assets. Let us first try to understand why the government is doing this? Why the government is wary of the systemic risk?

Economist will typically agree that systemic risk is a very important feature of the banking system which is part of the overall financial system. In a very strong and logical way this risk happens when we experience systemic events. In this event, bad news are typical narrow way or the contagion approach and widespread shocks are a typical broad way or the fundamentalist approach. In the contagion approach noisy signal is received by depositors (who imitate each other) about health of banks leading to withdrawal pressure on banks. In the fundamentalist approach, which has more significance in the current world, losses of borrowers (stressed assets) lead to bank failures and/or unwarranted curtailing of loans endogenously because the banks are now more alert. One also has to understand that both these approach magnifies economic downturn. One also has to understand that banks are not the originators of these distress or the shocks. This risk is of concern because of the following three reasons:

First is the financial instability hypothesis which say that financial crisis are widespread because economic prosperity encourages both banks and borrowers to be more optimist and reckless. This leads to instability and market failure. The issue here is with efficiency, information flow, and self-fulfilling expectations. The solution is government regulation.

Second is the financial fragility hypothesis which is connected with banks balance sheets, and issues like maturity transformation verses lending, investment in correlated assets, and the level of control with respect to borrowers promise to pay. Again the solution is government regulation.

Third is the government policy (regulation itself), its rational and importance with respect to supervision, management of crisis, lender of last resorts (the central bank), macroeconomic stability through proper supply of money and capital requirements.

Thus, the need for recapitalization plan with respect to the regulation issues. This with the reform package with respect to the psychological and the physical issues is spread over six themes and a goal -‘Enhanced Access and Service Excellence or EASE’. Now the question that arises is whether these themes are enough to stop creation of stressed assets on a continuous basis by these banks or its purpose is pure reform. The second question is which banks should have received these recapitalization funds– the strong one with adequate capital or the weak one who are wiping off their capital. In the current banking system, there are loans which are either stuck due to environmental issues or are under strategic restructuring. What happens if these also become NPA?  With this large amount of bad loans how long government would go for recapitalization of banks? This is our third question. 

The capital infusion plan includes ₹80,000 crore through recapitalization bonds and ₹8,139 crore as budgetary support. It is a welcome step that government is going to have major part of funding from issuing bond rather than using taxpayers’ money. Still the hidden fact here is that the interest cost of these bonds as well as the principal may ultimately be paid from the taxpayers’ money if the banks continue to perform badly or through a ‘bail-in’ of customer deposits (read FRDI Bill 2017). Also, the ₹8000 crore that will be infused from the budgetary allocation is still the taxpayers’ money. Instead the government should come with immediate strict policies with new regulations on the defaulters of loans along with these themes and the Prompt Corrective Actions (PCA) framework on banks performance. These should include recovery steps starting within a month so that defaulters cannot escape away. Any delay in this aspect should lead to strict accountability of the top executives and strict action should be taken. In simple words, PCA should also be initiated for the defaulters also.

This answers all our questions. This will help in reducing our stressed assets and the funds can be used for reform purpose. The funds should go only to the strong banks to add value to the banks. The weak banks will have to perform or perish by way of being merged synergistically with the strong banks. 

Overall, the stream of reforms has just started. The new reforms include the performance based capital infusion and the whole time directors to oversee reform processes. The reform plan is also having a positive sense of rural financial inclusion. So in one shot the government is planning to do many things altogether, of course related to each other.

But all the above is possible only when the PSB themselves change fundamentally its operation and management approach breaking through what is known as the physical, the regulation and the psychological barrier or the issues. Their actions should be proactive to take on the dynamic environment and the competition. All these coming together will definitely make the move of government to have recapitalization with reforms a welcome step but the journey has just started.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

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banking recapitalisation opinion

Pankaj Baag

The author is Professor Finance, Accounting and Control at Indian Institute of Management Kozhikode

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Mohd. Gyasuddin Ansari

The author is Fellow Program researcher in Economics Area at IIM Kozhikode

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