Why you should not rush to invest in PSU banks stocks just yet
Posted by: Uma Shashikant on Oct 30, 2017, 06.30 AM IST
Should we worry about or welcome the government's announcement to recapitalise banks? Since the stock markets have responded with euphoria, is this a positive move? Will this revive the economy and bring about the much-needed recovery? Should one buy stocks of public sector banks now?
Banks can simply borrow to make loans. They technically need equity capital only because loans carry a risk of default. A bank balance sheet with Rs 100 as deposits and Rs 100 as loans will mean a default on deposits every time a loan fails. It is not possible to make loans without taking a risk, but the amount of risk a bank can take should be capped given that deposits are raised from the public.
That cap is imposed by equity, first contributed as capital and then accumulated as the bank remains profitable. If a bank has Rs 8 as equity, it can give Rs 100 as loans, raising Rs 92 from the public. The Rs 8 represents the maximum limit on bad loans. The equity of a bank is the safety net for its depositors. That is why it is called capital adequacy. Without that cushion a bank cannot and should not lend.
What happens when defaults mount? The equity of the bank is eroded, and the bank technically cannot lend anymore as its capital adequacy is low. This is one of the reasons why credit growth of the banking sector has been low for several quarters in a row, leading to an overall slowdown in economic activity itself, since credit expansion is what drives the economy. When banks lend, they actually create money and move money across various users.
What is loan for one bank is deposit for another, as the borrower puts the money into the banking system. This deposit then is the base for another loan, which is turn creates another deposit against which a loan can be made. This expansion of money facilitated by banks is what oils economic activity and growth. If it happens too much and too fast, it also causes inflation as then too much money is circulating in the system without adequate absorption for productive purposes.
How is it that banks with high NPAs continue to function? Banks are governed by various rules regarding the accounting of their assets. Therefore, a bank that made a loan of Rs 100 and found that Rs 10 of that loan is likely to go bad, it will not immediately write down its assets to Rs 90 and declare the equity as wiped out. It will resort to the well-known practice of provisioning.
What this means is, the bank takes it time to declare the loan as doubtful of recovery, and each year it writes down a portion of the loan. This is what we know as provisioning for bad debts, or reducing the profits by an amount representing the loans that are tough to recover. Thus, the assets on the bank’s balance sheet may not fully reflect how much has gone bad. RBI went to work on this problem, tightened the provisioning norms, and forced banks to recognise and provide for bad loans. PSU bank stocks have been hammered down ever since this process began a few years ago. What happened as both NPAs and provisioning increased is that there was not enough capital to make any more loans. That is why the need to recapitalise banks.
In the early 1990s, a similar exercise was done when PSU banks were in too much of bad debt. The Narasimham Committee asked for the sector to be opened to the private sector. We remain grateful for that foresight. Then Finance Minister Manmohan Singh, while issuing bonds to provide equity to failing PSU banks, asked that their lending mistakes are not repeated.
PSU banks then sold equity shares to the public at throwaway prices. Those investors are the current diehard fans of this sector. Bank treasuries were allowed to invest in equity, so one bank supported the other, and the trusted institutions chipped in as they do with government initiatives. We thus know from history that recapitalisation is not the lasting solution to the NPA problem.
What is the government doing now? The government will buy shares of PSU banks for Rs 18,000 crore; banks will raise another Rs 58,000 crore from the market; and bank recapitalisation bonds for Rs 1,35,000 crore will be issued to buy more PSU bank shares.
What is this move likely to do? First, it will make it possible for PSU banks to lend all over again, as they will have better capital adequacy ratios. Second, the availability of capital provides an opportunity to clean up the assets, write off what is bad and recover whatever value is possible. Third, a qualitatively better balance sheet will make it possible for banks to restructure themselves. The euphoria in the stock market is largely due to these positive effects.
What is the downside? First, it is not clear whether cleaning up the books, selling off the assets and tightening the lending process is a pre-condition for recapitalisation. Some of the weakest PSU banks must be allowed to die. Will better banks get a preference for accessing capital? Second, the bonds may be bought by the banks themselves, presumably as part of SLR requirements, so we have a circular resolution of banks lending to government and the government buying bank equity shares with that money. Third, the bailout might just let the defaulters off the hook if banks are not forced to recover the NPAs and bring defaulters to book.
What happens now? First, ownership pattern of PSU banks will dramatically alter. Approximately 27% of the new equity is being issued to the public, the remaining 73% being brought in by the government (58:153). The government holding of all PSUs will move up and this will technically be the unintended third nationalisation drive. That’s a far cry from privatization of inefficiently-run PSUs.
Second, defaulters will be emboldened by the recapitalisation, seeing it as a bailout. Everyone knows that the big defaulters in PSU banks are politically connected. If PSU banks do not seize this opportunity to go after them, another opportunity to clean up both the banking system and Indian business would be lost.
Should one buy PSU bank shares? Only those banks that get after their defaulters and aggressively recover whatever is due will be worth it. PSU banks that clean up their assets and resolve to keep them that way, is a good bet. Only time will tell if we still have PSU banks with the guts and gumption to seize this opportunity.
(The author is Chairperson, Centre for Investment Education and Learning.)
Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com. This article appeared in Economic Times dated Oct 30, 2017, 06.30 AM IST