Should we recapitalise the banks?

Business Standard, 20 August 2017

As the banking crisis unfolds, banks will be short of equity capital. There will be calls for taxpayers to invest in private or public banks. The exchequer is unable to absorb such a shock, and it is a bad use of money. We have the luxury of time, and the opportunity to address this at the root cause.

Banks in India have a leverage of 20 times. That is, they use Rs.5 of equity capital and Rs.95 of deposits to create a pool of Rs.100 which is then invested into various assets. A loss of over Rs.5 gives a bankrupt bank. If we estimate that NPA recoveries average 20%, then a bank is bust when its true NPAs are 6% of total assets.

Many banks in India are in this state. There will be a clamour to use taxpayer money to give new equity capital to these failed banks. Is this a good use of fiscal resources?

Indian public finance is not ready for this shock. Nobody knows how much money is required, but estimates range from 4% of GDP to 10% of GDP. Medium term fiscal planning has not geared up for this in the last few years. Given the infirmities of how the government borrows in India, it is hard to greatly increase borrowing. We are some years away from setting up the Public Debt Management Agency (PDMA), scaling back financial repression, and setting up a modern borrowing arrangement. In the short term, a large jump in the deficit is not a choice for policy makers.

Even if this were feasible, is it advisable? The Marginal Cost of Public Funds in India is roughly 3, which means that the cost to society of Rs.1 of government expenditure is roughly Rs.3. Should we impose a cost of Rs.30 trillion upon society in order to give Rs.10 trillion to banks? This seems like a poor use of money. For a sense of scale, the first three phases of the Delhi metro added up to an expenditure of Rs.0.7 trillion.

It is argued that a large banking system is integral to prosperity and we should just hold our nose and write these cheques. This position is questionable at several levels.

Imagine a country where the State capacity for air traffic control was lacking, so that planes regularly crashed. Would we insist that air travel is integral to modernity, buy a new plane after every crash and start over each time? No. We would say that air traffic control is essential, and clean up the State capacity before the planes start flying. In similar fashion, our priority should be to address the policy failures of our banking crisis, not to paper over the problem with taxpayer money.

We are lucky to have a small banking system. The total non-food lending by all banks is Rs.76 trillion. Compared with this, the equity capital -- in only the top 2429 companies -- is Rs.127 trillion. In countries like Japan and China, a banking crisis was a more intractable problem, as bank credit was a dominant player. India is a market-dominated financial system, and that gives us room to maneuver.

In the long Indian historical experience, a healthy rate of growth of non-food credit has been 11% in real terms. At the inflation target of 4%, this translates to a nominal value of 15% annual growth of non-food credit: this is what keeps the economy working well. If we put banking in the Intensive Care Unit (ICU) without an easy bailout, we may get growth of roughly 0% nominal in non-food credit. This is a shortfall of Rs.11.5 trillion per year of capital going into the economy. Are there levers through which this shortfall can be made up?

There are ample opportunities for policy makers to get more capital, through non-bank finance. This includes building the equity market, building the bond market, liberalisation of market-based capital flows, liberalisation of NBFCs and creating the space for the `fintech' revolution with new technology-intensive players in finance. It is possible to find the reforms which will generate additional Rs.11.5 trillion per year flowing through these channels, and thus offset the stagnation of bank credit while banking is in the ICU.

India is a market dominated financial system, and the gap in bank credit growth is not an alarming one. We can survive 0% growth in bank credit, by pushing these five levers of policy that yield an additional Rs.11.5 trillion per year of capital for the economy. The banking crisis is a problem, but it need not overwhelm the macroeconomic situation.

With this fear out of the way, now let us think about what to do with the patient once he is in the ICU. Look back at our success stories.

We had a problem in UTI in 2001. What did the Ministry of Finance do? Half (but not all) the cost was borne by the taxpayer; the UTI Act was repealed; the viable part of UTI was privatised and placed under SEBI regulation; SEBI regulations were strengthened to put an end to the things that the old UTI was doing wrong. There has been no mutual fund crisis after 2001.

We had a problem in stock exchanges in 2001. What did the Ministry of Finance do? The old `badla' trading was shut down; it was replaced by derivatives trading which required an amendment to the SC(R) Act; the BSE was demutualised so as to achieve three-way separation between shareholders, managers and trading members of stock exchanges. There has been no stock market crisis since 2001.

We did not merely use taxpayer money and get back to business as usual; we solved the problem at the root cause. This scale of work is required at the Ministry of Finance. When trillions of rupees are lost, there needs to be a reckoning. What went wrong? How do we make sure this never happens again?

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