Governments change, but the method of governance generally does not. The methodology of providing additional capital to public sector banks, which started in 1990s, has not changed over the years in spite of change in the political administration of the country.

The RBI Governor has suggested that banks raise capital on anticipatory basis to build up adequate capital buffers to mitigate risks arising out of the coronavirus outbreak. He said that building buffers and raising capital would be crucial not only to ensure credit flow but also to build resilience in the financial system.

This is a well-thought-out suggestion as banks are facing difficulties on account of large-scale default by borrowers.

They are likely to have huge non-performing assets after the extended moratorium period is over. This will erode their profitability. Banks’ capacity to lend further will be affected due to dilution in their capital-adequacy ratio. Hence it is a sane advice to plan ahead for additional capital. But how the capital is arranged also matters.

For private banks, the source will be to tap the market with public issues or to make preferential allotment to institutional investors. For public sector banks, the government generally provides capital by way of recapitalisation bond.

In an October 24, 2017, announcement, the Government decided to infuse ₹2.11 lakh crore capital into public sector banks over the next two years. Out of this, issue of recapitalisation bonds by the Government was for ₹1.35 lakh crore.

India had also used this tool in the FY1986 to FY2001 period, wherein the government recapitalised public sector banks with a total amount of ₹20,446 crore. It borrowed the amount from the banks and issued special non-marketable securities, which were, however, later converted into marketable securities or perpetual bonds.

Recapitalisation benefits

Any recapitalisation will strengthen the capital base of the banks. It will help them write-off bad loans and subsequently increase their lending capacity.

The banks are governed by Basel-III norms as adopted by the Reserve Bank of India. As per these norms, banks must have sufficient capital-adequacy ratio (that is, the ratio of capital to the risk-weighted assets of the banks) at different cut-off dates. Failure to have the prescribed CAR will result in embargo on further credit disbursals. More capital is required to be able to give more loans.

But instead of providing actual capital to banks, the government adopts an accounting method through which it provides funds to the banks by one hand and takes them away immediately by the other hand. This is an accounting jugglery or gimmick. Or we may call it some sort of window-dressing.

Through this method, the government asks the banks to subscribe to government recapitalisation bonds for the exact amount that is released to them as capital. So banks will receive capital and the same amount will be invested in government bonds also. Both assets and liabilities will increase for the like amount.

This is similar to financial engineering used by some companies, wherein methods are adopted to make a company’s financial situation seem better than it really is.

When the bank invests the amount received in the government bond, how will it increase the lending capacity of the bank? No doubt the bank will have a better capital-adequacy ratio. That is all. The bank also may get interest on the bond, which it can take it to its profit and loss account.

The government is also comfortable with this arrangement because there is no outflow of funds while providing capital, and it has to only arrange for interest payment. That way the fiscal deficit is managed.

Banks are supposed to invest in government bonds only as part of their Statutory Liquidity Reserve requirement, which is based on their net outside liabilities. Making them subscribe for government bonds out of capital provided defies all logic and the mechanism of SLR.

In many banks, government shareholding is much more than 51 per cent. Instead of indulging in this accounting gimmick, the government may authorise banks to take capital through public issue. This will not dilute the majority ownership of government.

It is also possible that the government can have majority control even after holding less than 50 per cent of capital with necessary amendments to the law pertaining to government banks.

Funds infusion through public issue will actually augment the banks with necessary capital and the government will not have the need to provide for additional capital every now and then. This will also force banks to operate efficiently as they will be answerable to more public shareholders.