Need For Banks Recapitalization?

Need For Banks Recapitalization?

Various Articles and opinions speak about the need for increasing the capital of PSU Banks.  What is the current need for such a step?  Let us analyse the same as under.


Basically, banks create money. For example, if I lend you money, and you put it back in a deposit in my own bank, it results in my creating money.  Similarly, I put money in the bank deposit & bank lends it to some other person or bank lends me money and in turn someone else puts it in the bank deposit, effectively all these amount to the same.

Thus, it is clear that the order does not necessarily matter for the banking system.


It is their Capital.  Let us see how.

  1. For every loan a bank makes, it needs to have 10% of it as capital. So if a bank holds a capital of Rs 100, precisely it means the bank can extend loans to the tune of  Rs. 1000.
  2. Now if the bank loses Rs. 50 on these loans released, due to somebody’s failure to repay, (let us say 5% NPA) then the bank’s loss hits its capital.  Thus, the capital falls to Rs. 50.   Consequently, now the bank has only Rs. 50 on Rs. 950, or ~5% as capital.
  3. So at this point the bank has to raise Rs. 45 as capital to come back to 10% capital ratio. Or, it has to somehow call in loans of Rs. 450.  Calling in loans is not possible, which results in banks’ stopping further lending. This is what has happened.
  4. Public Sector Banks have frozen up on lending because they cannot lend more, as their capital ratios will not permit further lending.
  5. The result is, Banks hold Rs. 100 as capital and have lent Rs. 1500 (resulting in 6% capital ratios). They have ended up in a loss of Rs. 50 about which they are aware of, and hence are unwilling to take (Net NPAs).


  • In view of this, the government has proposed to give the banks Rs. 50.  With this contribution from the Government, the Banks’ capital increases to Rs. 150. After this, the banks take the Rs. 50 loss.   Thus, they will have Rs. 100 capital on Rs. 1450 lent.
  • Better capital ratio than earlier! Magically, things change. Because of better capital ratios, banks can now raise more capital – say another Rs. 50 is raised.
  • The result is that the banks now have the ability to lend another 500 rupees, to maintain a capital ratio of 8%. This is a higher capital ratio than earlier.
  • The ultimate result would be that the credit portfolio will increase, though the losses through the NPAs still exist.  The Government thus is forcing banks to absorb the losses, and push the NPA to real losses, since the Government now replenishes the capital that is lost.


Now, the Challenge before us is as to how the Government  The question here is, how will the Government get Rs. 1,35,000 crore more?  What are the avenues and channels available when already the deficit is 500,000 crore?  Here comes the answer through the process of financial engineering.

  1. Government will issue bonds which should be bought by the banks.
  2. Here the banks will provide funds to the Government, which in turn will buy shares in these banks.
  3. The banks get to keep this money; they get bonds and issue shares in exchange.
  4. This precisely means that the banks providing their promoters (ie., the Government) money to buy their own shares.


  • Providing banks capital means they are being forced harder to take losses.
  • However, absorbing losses is not easy – Here, the banks have to auction off the collateral, seize assets and recognize the loss that impacts the capital.
  • Hitherto, banks were taking the excuse that recognizing losses would hit their capital ratios.
  • A low capital ratio means investors would not put in more money, which means, banks could not lend anymore and good borrowers were saddled with the bad borrowers.
  • Now, the government allows banks to go to NCLT.  It allows them to issue themselves shares of their defaulter companies, so that they own the companies and can auction off the assets (or get a new promoter to run it).
  • This freedom was not extended in the past, and with this change in norms, now banks have to be pushed to recognize losses fast.


  1. Nothing happens to the promoters, even if they pretended and extended these NPAs too long.
  2. In effect the banks should take over the defaulting companies. Recognize full losses & sell all the assets in a mega auction.
  3. Do not allow the promoters or relatives to bid for these assets or own them for five years later.
  4. And with what they recover, it comes back as capital because they recognized a full loss and later recovered something back.
  5. More so, marking down the loss of a loan does not mean the promoters get away. The recovery is still pursued and whatever is recovered becomes a profit.
  6. Thus, banks need to go into aggressive recovery mode.


Till now it is not clear as to what type of bonds are going to be issued. Following are questions that arise:

  • Will they be tradable?
  • Will they qualify for SLR?
  • Will they be issued directly to the banks that get the capital, or to the players in the market?
  • It may be recalled, that during 90s, the Government resorted to such efforts, through issue of recapitalization bonds to the banks themselves and in turn, these bonds were non-tradable at first, and did not qualify for SLR and later were either converted to equity or made into perpetual bonds.


  1. Dilution would be an issue.  Here, a bank with Rs. 100 book would just get diluted by Rs 50 from Government and Rs 50 from private.
  2. For e.g. let’s assume ABC Bank, will need about 7000 cr of capital if they have written off  60% of their net NPA.  Let us suppose that the market cap of ABC Bank is only 5200 cr.  So if they get 7000 cr of capital from the government, and issue shares at current prices, all current share holders get diluted more than 50%! (If your holding is 1% of the bank earlier at Rs. 52 cr and the bank saw Rs. 7000 cr injected, you now own only 0.4% of the bank)
  3. This will also increase Government holdings – in ABC Bank, for example, the government owns 70%.  If they bought Rs. 7,000 cr more then the Government will possess 87%, if all of the infused amount is borne by the Government only.


  • For bond market players, an additional of Rs 135,000 cr of bonds would come under non-marketable category.
  • Thus, the buying banks will not be able to sell the bonds, and thus there will not be any additional supply. Hence the impact on the yield is likely be neutral.
  • Also, on the inflation front no adverse impact would be seen, in the foreseeable future since the government remains committed to low inflation which has been explicitly expressed by the Government time and again.


There is likely to be an impact on the Fiscal deficit for the FY 2017-18. Reasons are:

  • Effectively the government invests money into the banks.
  • That investment is called an “outflow”.
  • The Fiscal deficit is = All Inflows minus all outflows except the part that involves borrowing.
  • However, we may say that hitting the fiscal deficit is permitted, since India is in a potential growth crisis. Also, in order to bring things back to shape, the fiscal deficit can be allowed to widen.
  • Since there are other issues with the capitalization, widening of Fiscal deficit should be construed as a noteworthy risk.
  • In terms of RBI’s assessment, the recapitalization bonds will be liquidity neutral for the government except for the interest expense which would form a part of annual fiscal deficit numbers. RBI thus does not view it as a fiscal impulse.


Nothing is clear as to which bank would get the most benefit, how and when?  Overall, the move can be construed to be a good reform measure, which would bring forth the credit growth and provide for economy’s growth.


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