The Indian government on 24th October 2017 unveiled a plan for massive capital infusion of INR 2.11 lakh crore into public sector banks (PSBs) over the period of next two years, giving them after Diwali gift. Many people want to know the effect of this recapitalization on mutual funds.

The idea of infusion is to strengthen the lending capacity and improve credit growth among PSBs that are saddled with a heavy, non-performing assets (NPAs) as well as are struggling to meet capital adequacy ratio by FY-2019. The bigger PSBs like SBI, PNB and BOB are likely to be the key beneficiaries of this capital infusion plan.

Of these INR 2.11 lakh crores of capital infusion, INR 1.35 lakh crores will come from recapitalization bonds, which are systematic financial products and no cash flow involve. Of the rest amount, about INR 18000 crores will come from the budgetary allocations of 2017-18, and INR 58000 crores to be raised through the market by divestment or equity expansion by PSBs.

The move is extremely critical for the slowing Indian economy, as private investments remain elusive due to the serious problem of a twin-balance sheet. Several economists around the globe welcome the move for the recapitalization of PSBs, having the potential to revive the private investment in Indian by lending more freely. At a time when the global economy is recovering, the move is also critical for reviving the growth momentum of Indian economy.

History of Capital Infusion in Indian Banks

old coin capital infusion

Recapitalization of banks i.e., capital infusion into the banks started in India in the 1990s, when the Indian economy was on a downward growth trajectory. Because of the trade-off between the fiscal deficit and the extent of capital infusion, there has been a limit to how much the centre can infuse from the state coffers. According to media reports, as much as INR 20,000 crore was infused into PSBs through this method in the 1990s. In 1993-95, the then UPA government introduced recapitalization bonds to help distressed Indian banks. Recapitalization bonds are considered as less disruptive for government finances though the bond market (as a whole) is expected to be the biggest casualty irrespective of the route that will be finally chosen to issue them.

Let’s see what recapitalization bond really is? A government bond is a financial instrument to raise money from the market with a promise to pay a periodic interest and to repay the face value on maturity. Recapitalization bond is a bond issued for the purpose of recapitalization of banks. Whenever the banks require liquidity, the government will issue recapitalization bonds. Banks will lend money to the government for subscribing the bonds and enter it as an investment in their accounting books. Money raised by the government through recapitalization bonds will go back to the bank as capital, which will strengthen the banks’ balance-sheet as well as will show strong capital adequacy. With this lending of money to the government for subscribing recapitalization bonds, the problem of a bad loan will not arise as the government is always solvent.

It does not have an immediate impact on the fiscal deficit target of the government. However, it also depends on how it is being accounted in the books of the government. According to Arvind Subramanian, the Chief Economic Advisor to the government of India, it does not add to the fiscal deficit, but as per IMF chief, it does as sooner or later, the government would be liable to pay the interest and face value of the bonds on maturity. However, since it is a long-term debt, it provides time to banks to improve their balance-sheets by increasing their credit and private investment.

In current capital infusion, the interest burden for INR 1.35 lakh crore recapitalization bonds on the Indian government would be about INR 9,000 crore per year, but Chief Economic Adviser of Indian government, Arvind Subramanian says this interest cost can be offset by boost in economic activities due to increased credit with the banks and private investment.

In 2015, the newly elected Modi government at the centre, announced capital infusion of INR 70000 crore in PSBs under the umbrella scheme “Mission Indradhanush” over the span of 4 years. The plan proposes infusion of around INR 25,000 crore in 2015-17, followed by around INR 10,000 crore in each of subsequent years till FY-2019.

Last time capital infusion was done by the Indian government was in July 2016 in order to boost the credit growth in the economy. It infuses a sum of INR 22,915 crore for recapitalization of 13 PSBs.

Why is Recapitalization of PSB Required Right Now?

coins capital infusion

To Improve the Capital Adequacy Ratio:

Capital adequacy ratio, in simple terms, is a measure of a bank’s capital. PSBs, struggling with poor capital adequacy ratio, can take some fresh breath with the latest recapitalization plan by the centre. The recapitalization plan will provide the capital to the banks to meet the capital adequacy ratio under Basel III norms. Basel Norms are the set of international banking regulations put forth by the Basel Committee on Bank Supervision, which set out the minimum capital requirements of financial institutions with the goal of minimizing credit risk. Currently, all banks across the globe follow Basel III norms. Rating agency CRISIL has estimated that PSBs, to meet the international Basel III norms, will need about INR 1.4 -1.7 trillion of additional capital by March 2019.

To Tackle the Problem of NPA:

The Indian banking system is piled up with a huge amount of bad loans, also known as stressed assets. These stressed assets for Indian banks are close to INR 10 lakh crore now, which is more than the GDP of nearly 140 countries, and it is only growing. Bad loans, which in majority include NPAs, consists of around 12% of the total loans disbursed by the banking system now. A loan becomes an NPA when borrowers have stopped repaying the principal amount or the interest on them and have slim chances of recovery. PSBs are doing worse in terms of NPAs accounting for 70% of the total in India’s banking system. In the developing economies like India, this issue of mounting NPAs is giving jitters across the banking system.

The incidence of NPAs is rising at a fast rate and has been attributed to the sluggish economy of India. Indian banks need to work on ways and means of recovering NPAs at the earliest. The recovery process in India is usually extremely long, sometimes taking up to 10-15 years. On an average, India takes nearly 4 years to declare a promoter or a company insolvent, which is more than twice the time taken in the US and in China. While the new bankruptcy law passed in May 2016 aims to shorten this time period, the framework to implement it still isn’t in place yet. Most recently, on 14th June 2017, the RBI directed that the top 12 large borrowers, which account for 25% of the stressed assets in the country, be immediately taken to bankruptcy courts. This new move is likely to speed up things, showing the stick to the promoters and keeping creditors in control.

The capital infusion by the centre now comes after the Indian Bankruptcy Code has imposed valuable deadlines on banks, forcing them to take haircuts and revive assets if necessary with new promoters. Re-capitalisation of PSBs is very important, considering their overwhelming domination of the industry. The capital infusion should strengthen PSBs to start reforming their processes, taking vigorous action to resolve NPAs and resume lending. The latter is vital for the sluggish Indian economy.

To Revive the Sluggish Indian Economy

The move like demonetisation, to scrap a majority of currency in circulation on 8th November 2016 and the rollout of a wide-ranging tax reform like GST (goods and services tax) on 1st July 2017, has disrupted the growth momentum of Indian economy. Other factors like low private investment and sluggish exports are also responsible for this slowdown taking GDP of India as low as 5.7% in Q1 of 2017, losing its title of the fastest growing economy to China. The additional capital infusion is vital for the recovery of the sluggish economy. It will increase lending which in turn will spur growth numbers, therefore increase tax collections, creating employment across various sectors and partly bring down the fiscal deficit. The Government has indeed taken a well-integrated initiative to sustain domestic demand and growth while creating employment.

Impact of Capital Infusion on Indian Stock Market

Indian Benchmark indices, BSE Sensex and NSE, closing at a record high on 25th October 2017, with the news of capital infusion of INR 2.11 in PSBs spread over two years in a bid to aide private investment, support credit growth and revive growth in Indian economy. The 30-share BSE Sensex closed all-time high at 33,042.50 and the 50-share NSE at 10,295.40. The rally was led by stocks of financial institutes after all the Indian Banking and financial stocks constitute nearly 40 percent of the index weight; hence, any big move in shares like SBI, ICICI Bank, HDFC Bank will support the rally.

SBI and PNB hit their respective 52-week highs. India’s biggest lender SBI surged nearly 26%, its biggest single-day jump since January 1994. PNB was the biggest gainer among large caps, rising 36 %. Among other banks, Bank of Baroda (BOB) was jumped by 26%, Bank of India (BOI) and Union Bank of India (UBI) rallied 21%, Canara Bank up by 20%, Corporation Bank up 20%, Oriental Bank of Commerce up 19%, Indian Overseas Bank, IDBI Bank and Uco Bank rallied to16%, Andhra Bank up 15%, Central Bank of India were up 14% and Allahabad Bank jumped to 13%.

However, except for ICICI Bank and Axis Bank, and other non-banking financial companies (NBFCs), shares of private banks are under pressure. ICICI Bank shares rallied 10%, while Axis Bank shares were up by 1% in morning trade. HDFC Bank, Yes Bank, Kotak Mahindra Bank, IDFC Bank, RBL Bank, IndusInd Bank, South Indian Bank and Federal Bank were trading either fell or flat.

Impact of Capital Infusion on Mutual Funds

Recently, a lot of mutual fund houses had abandoned the banking sector companies especially that of the PSBs due to the problem of heavy bad loan issues and also this fund category has been declining for a while. But after the recapitalization news, fund managers of big fund houses believe that it is a good bet to have an exposure of the banking sector by investing in a sector fund. This is the right time for investors to look into the banking sector as Indian banks form a significant part of the stock market and are essential part of mutual fund portfolio.

Looking at Indian debt market, there will be no major impact of this new move by the government. The yield on bonds came down only slightly from 6.80% to 6.79% after the announcement of capital infusion to PSBs. In long run, the idea of infusion is to strengthen the lending capacity, expected to mitigate losses and improve credit growth among PSBs, which will eventually bring down the lending rates for banks and will results in the increase in bonds yield. Currently, both equity and debt market are welcoming this move as it is a well thought move to fast track revival of the sluggish Indian economy.

capital infusion effect on markets

Challenges of New Infusion Plan in the Coming Months

Challenge in Raising Cash Through The Market:

The fresh infusion plan, involved INR 76,000 crore of cash flow to the PSBs, of which INR 18,000 is expected to come from the budget in 2017-18 and rest INR 58,000 through the market by divestment or equity expansion. But there is a big challenge for PSBs in raising capital through the market as apart from SBI, no other PSBs has strong financials to raise money at a higher valuation.

No Clarity on Recapitalization Bonds

Of the INR 2.11 lakh crores of capital infusion, INR 1.35 lakh crores will come from recapitalization bonds, which are systematic financial products and no cash flow involve. But there is no clarity on these recapitalization bonds. Many questions are yet to be answered like “Who will issue and subscribe to such bonds? Will there be interest on them? If Yes, how much will it be? and who will pay the interest on these bonds?”. These will have implication for the issuer (if the government issues it) in terms of widening of fiscal deficit.

Capital Wastage in Cleaning Up Existing Mess

As more than half a dozen PSBs are under the preventive corrective action (PCA) of the Reserve Bank of India, most of the new infuse capital will go down the drain. When there is a drastic fall in the capital levels, lower profitability and higher NPAs, the RBI puts banks under PCA. The bankruptcy proceedings and asset quality review have already put additional NPA provisioning burden on PSBs.

To divide the fresh capital, the Indian government needs to trade-off between what part of the fresh capital will go for provisions against existing bad loans and how much is to be allocated for new loans. Given the weak demand for loans, allocating new loans not seem a crying matter right now, but it is possible that companies will start borrowing after a few quarters if the investment cycle does indeed turn in FY 2018-19.

Proper Allocation of Capital Among PSBs

Capital infusion of this kind brings in the fears of moral hazard that adequate precautions will not be taken by banks to lend money when they know that the government will provide help if loans turn bad. So, the government need to be very selective to divide the additional capital among PSBs. As stated by the governor of Reserve Bank of India, Urjit Patel, the PSBs which have worked really hard and have shown improvement in dealing with their NPAs problem will get preference in access to the fresh capital. The weaker PSBs should be given capital only to maintain their current process. Such market discipline is very important and needed at the moment.

Proper Governance and Reforms Required

PSBs are suffering because of the lack of governance which includes their archaic systems and processes. We are in the middle of 4th revolution and technology is transforming the banking industry at very rapid pace. PSBs are lacking in technology and digital banking, which is keeping them miles away in the race when it comes to Fintechs or private banks in India. Capital alone won’t resolve these issues, they really need to catch up a lot. The reform of the Indian banking sector, especially in PSBs, should be the next step.

Some of the top banking funds are ICICI Prudential Banking and Financial Sevices Fund, UTI Banking Sector Fund, and Invesco India Banking Fund.

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Disclaimer: the views expressed here are those of the author. Mutual funds are subject to market risks. Please read the offer document before investing.