A question of letter and spirit

In recapitalising public sector banks by borrowing from banks themselves rather than from market, the govt is violating the spirit of Basel capital adequacy norms

Public sector banks (PSBs) in India have incurred huge losses over the years, which have been eroding their equity capital. On October 24, the Government of India (GOI) announced a Rs 2.11 lakh crore plan for recapitalisation of PSBs. Of this, Rs 1.35 lakh crore is to be financed through the so-called recapitalisation bonds (or, R-bonds) and the remainder through budgetary allocation and fund-raising from the markets. This article is about the mode of financing through R-bonds. There are, as we will see, issues of financial instability and financial repression involved in this context. 

After the scheme is implemented, R-bonds will become assets of PSBs and the (additional) equity capital will be on the liabilities side of their balance sheets. So, the GOI will effectively be investing in the equity capital of banks by borrowing from the same banks! It is true that the equity capital of PSBs will, under the Basel capital adequacy norms, nevertheless be enhanced with the use of R-bonds (and the PSBs will be able, after meeting the Basel capital adequacy norms, to lend more out of the deposits they anyway receive). However, there is an issue of letter and spirit. 

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 is that a bank’s equity capital should be raised from shareholders, from the latter’s own funds. These can be even borrowed funds but in that case the borrowing should not be from the very banks whose equity capital the shareholders are investing in. The GOI is violating this norm.

Illustration by Binay Sinha

Under the announced scheme, 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). The R-bonds will be issued by the GOI or a government-sponsored special purpose vehicle. Now, the international ratings of GOI bonds are quite low; the rating by Moody’s was Baa3 positive as on October 19. So, GOI bonds are risky. This, as research by this author shows in a paper (‘Seemingly safe banks in an emerging economy’) presented at the ISI Delhi Centre’s sixth annual conference on growth and development in December 2010, can negate the strengthening of the banks’ balance sheets through recapitalisation of PSBs, thereby defeating the purpose of capital adequacy norms. 

Such negation of Basel capital adequacy norms would not have happened if the GOI had decided to raise funds through normal bonds, and used the funds raised from the markets to recapitalise PSBs. In this alternative scenario, on the asset side of the PSBs’ balance sheets, there would primarily have been bank loans instead of (additional) risky GOI bonds. 

Besides the low ratings, there are other facts that support the view that GOI bonds are risky. First, unlike the ratio of fiscal deficit to GDP, which is not alarming, the fiscal deficit is a whopping 26.52 per cent of the total receipts of the GOI (Reinhart and Rogoff have suggested this alternative metric in their well-known 2009 book, This Time is Different — Eight Centuries of Financial Folly, to gauge fiscal conditions). Second, though the nominal interest rate on 10-year GOI bonds is not very high at 6.808 per cent as on October 27, (considering the pre-announced four per cent inflation target), this number needs to be used carefully. This is because there is a captive market for GOI bonds, given that banks and key insurance firms are formally or informally required to buy and hold government bonds. This ensures that, notwithstanding the intrinsic risk, the yields on such bonds are lower than what they would have been in a truly free market for bonds.

It is interesting that though there is an intrinsic risk in GOI bonds, there may not be any fiscal crisis at all due to their captive market. Now we have an irony here. The very fact that banks hold such bonds can make these instruments safe in practice for banks! This, in turn, implies that there may not be, in practice, any issue of a banking crisis related to banks’ holdings of government bonds. This is fortuitous, but there is no free lunch.

If banks are required to hold GOI bonds, then bank credit is adversely affected. This affects the real economy. This is a real cost that the economy incurs for avoiding a banking crisis or fiscal crisis despite the use of intrinsically risky government bonds. We are familiar with this in  economics literature as the (social) cost of financial repression, though this usually gets underestimated, if not overlooked; see, for example, the 2011 book, Growth With Financial Stability by Rakesh Mohan, former Deputy Governor of the Reserve Bank of India. 

It is true that R-bonds have been used in the past in India and elsewhere, but that is not a good reason to use them again. It is also true that with normal GOI bonds (instead of R-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.

If banks are recapitalised through R-bonds, then banks hold more of the risky GOI bonds than bank loans; this is considering not just the present but also the entire duration for which the R-bonds will need to be held, even when there is more demand for bank credit than at present. It may be argued that given India’s experience with non-performing assets (NPAs) and stressed assets of PSBs in the past, bank loans can be riskier than the risky GOI bonds! This is an important point. But then that raises a more basic question. Why recapitalise PSBs at all in the absence of other meaningful reforms that can keep some check on NPAs?    

The author is Visiting Faculty, Indian Statistical Institute (Delhi Centre) and Ashoka University.

Published with permission from Ideas For India, an economics and policy portal