Published Article Details

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

Online Courses

Capital Markets
Basic Level
BANKING AND CAPITAL MARKETS

Get the training you need to work in the Banking and Capital Markets industry through this intensive course

Capital Markets
Basic Level
SECURITIES AND OPERATIONS PREPARATORY

This NISM preparatory training is designed to help students whowant to take the securities and operation ex

Capital Markets
Basic Level
DEBT INSTRUMENTS - BASICS

Get a complete understanding of debt instruments in India. This course is ideal for professionals who want

Capital Markets
Basic Level
EQUITY MARKETS BASICS

More people in India are investing in equities and shares creating a need for more skilled equity managers

Capital Markets
Advance Level
EQUITY LINKED STRUCTURED PRODUCTS

Structured products are used to introduce tailor-made investment options in the world of finance. Our cours

Capital Markets
Advance Level
DEBT INDICATORS

What factors affect the debt market? Learn all about debt market indicators to understand the world o

Capital Markets
Advance Level
DEBT MARKET ANALYTICS

Need help to understand the bond market? This bond valuation course simplifies debt bonds, bond yield

Capital Markets
Intermediate Level
CREDIT RATING

Poor credit ratings indicate risky investment opportunities. Learn about the concept of credit rating, its

Capital Markets
Advance Level
EQUITY VALUATION PRINICIPLES

Learn the different principles of equity valuation along with their real world applications.

Capital Markets
Advance Level
EQUITY MARKET INDICATORS

Reinforce your stock market basics by learning about equity market indicators through our online course.

Capital Markets
Advance Level
DEBT MARKETS LEVEL - 2

Understand the structure of debt capital markets and the structure of its primary and secondary markets.

Capital Markets
Intermediate Level
FINANCIAL PLANNING AND MUTUAL FUNDS

Learn to invest based on investment goals and objectives through our Intermediate course on Mutual funds.

Capital Markets
Advance Level
EQUITY MARKETS -II

Learn advanced methods of fundamental and technical analyses of financial statements in capital markets.

Mutual Funds
Basic Level
MUTUAL FUND PRODUCT PRIMER

People in India are increasingly knowledgeable about the investment options available to them. Mutual Funds

Mutual Funds
Intermediate Level
MUTUAL FUND FACTSHEETS

Become a mutual fund investment advisor. This course will teach you the basics of mutual fund investment th

Mutual Funds
Basic Level
PREPARATORY COURSE FOR NISM MFD EXAM

This NISM modules preparation training is designed to help students who want to take the NISM examinations

Mutual Funds
Basic Level
MUTUAL FUND PROCESS PRIMER

Acquire the ability to provide complete financial solutions to investors using mutual funds through underst

Mutual Funds
Advance Level
PERFORMANCE EVALUATION OF EQUITY FUNDS

Learn to evaluate a portfolio thoroughly through our advanced level course on portfolio evaluation!

Mutual Funds
Intermediate Level
EQUITY FUNDS - PRODUCTS AND POSITIONING

Learn about the different types of equity funds and their positioning through ourintermediate level course.

Mutual Funds
Intermediate Level
DEBT FUNDS - PRODUCTS AND POSITIONING

Learn about the types of debt funds and their positioning through our intermediate level online course.

Mutual Funds
Advance Level
MUTUAL FUND PRODUCT POSITIONING

Learn how to choose and understand mutual funds products with our online course on mutual fund positioning.

Mutual Funds
Advance Level
DEBT FUNDS - RISK, RETURNS AND PERFORMANCE

Learn to market debt funds and how to calculate their risks and returns through our advance level course.

Mutual Funds
Advance Level
FUND SELECTION AND SUITABILITY

Learn to choose the right category mutual funds based on your clients' risk profile and financial needs.

Mutual Funds
Intermediate Level
LIQUID FUNDS AND TREASURY MANAGEMENT

Learn how to invest in liquid funds for treasury management through our advanced online course. Enrol now!<

Stock Broking
Intermediate Level
DERIVATIVE TRADING-2

Master the basics of option trading strategies and learn how to balance profits, risks and returns us

Stock Broking
Intermediate Level
EQUITY TRADING - 2

Delve into the nuances of equity trading strategies. Hone your skills to gain maximum rewards through this

Stock Broking
Basic Level
TRADING ACCOUNT - COMPLIANCE

Understand the consumer redressal procedures used by broking houses, their clearance and settlement process

Stock Broking
Basic Level
TRADING ACCOUNT - LEVELS - BASIC CONCEPTS

Get started with the basics! Learn how trading and DEMAT accounts are different along with their opening an

Stock Broking
Basic Level
DERIVATIVE TRADING

Get the tools and knowledge you need to understand derivative products. Learn about the pricing of differen

Stock Broking
Intermediate Level
MARGIN LENDING AND TRADING

Margin trading and lending is a high risk and return strategy. Learn how it works from our online course.

Stock Broking
Basic Level
DEMAT ACCOUNTS - PROCESS

Learn how to open and operate DEMAT accounts through our beginner level online course.

Stock Broking
Basic Level
EQUITY TRADING - 1

Learn the concepts of equity trading and trading strategies through our beginner level online course.

Stock Broking
Advance Level
DERIVATIVE STRATEGIES

Gain a thorough understanding of the best options trading strategies through our advanced online course.

Stock Broking
Intermediate Level
IPO AND MARGIN FUNDING

Understand the IPO funding process in India and their benefits to investors through our intermediate course

Stock Broking
Intermediate Level
LAS, IPO FUNDING & LEVERAGE

Learn about IPO, ESOP financing structures along with loans against securities through our online course.