Banks today are flush with funds. Thanks to the deluge of deposits, post-demonetisation, there is no dearth of lendable funds in the banking system, including the public sector banks (PSBs). So, why is finance minister, Arun Jaitley, going to great length to re-affirm that government’s bank recapitalisation plans for the current fiscal are on track?
Remember, the government has already committed R25,000 crore each for FY16 and FY17, and another R10,000 crore each for the next two financial years as equity infusion into PSBs. However, as Reserve Bank of India’s (RBI) latest Financial Stability Report makes clear, the steady deterioration in the health of PSBs means these amounts are bound to fall grossly short of the recapitalisation needs of PSBs. If banks have enough and more funds to lend, why do they need more capital from a resource-starved government that is struggling to allocate scarce resources between multiple needs?
And, why is the government throwing away scarce resources into what seems to be a bottomless pit? Is it only to ensure regulatory compliance under Basel III? Or is there more to it?
Why is capital, and hence capital adequacy, so important for banks? Before one tries to answer that question, take a step back and consider why is equity capital necessary for a business. After all, businesses can be funded through equity or debt capital. Indeed, the well-known Miller-Modigliani theorem says there is no difference between the two. So, can a business be started or continue to be funded completely with debt?
The most common counter to this is that if an entrepreneur has no stake of her own, she will not be able to attract debt capital since she has no incentive not to take excessive risk. Economists call this ‘moral hazard.’ But this need not always be true. In a non-corporate entity, where the promoter has unlimited liability, there should be no scope for moral hazard. Indeed, a capital structure that is 100% debt should encourage profit-maximising behaviour since any surplus over the interest cost and debt repayment would accrue to the promoter. Besides, the fact that creditors can lay claim to the promoter’s personal assets if the firm’s assets are inadequate to recover their dues in case of default should align the interests of both parties.
So, is the worth of equity capital overstated? Not at all! Not in the context of limited liability companies or partnerships where the danger of moral hazard behaviour by equity-holders is both imminent and real. The reason is the ‘call option’ they effectively hold on the assets of the business. Thanks to the magic of limited liability, the greater the risk, the greater the chance of an upside; but downside risk is limited only to the extent of loss of equity capital invested. Debt-holders are in the exactly opposite position in this zero-sum game; as risk increases, their holding loses value.
Any crisis, whether at a firm, industry or economy level, skews the asymmetry further. A fall in operating profits is common in a crisis. At such times, losses could result in an erosion of capital. You could have a situation where value of assets go below the face value of loaned funds in the balance sheet. This means that if all balance-sheet assets are sold at their book value, an unrealistic assumption to start with, it would not be sufficient to repay the creditors. At such times, creditors might immediately panic and try to pull out their funds before the situation deteriorates; in the process aggravating an-already precarious position. The only thing that might prevent them from doing so is if they are certain there is an equity cushion brought in by shareholders that will first absorb the losses, before the debt capital contributed by them is impacted.
But in a scenario where an entity’s shares are being beaten down by the market, sourcing equity from the capital market will be difficult, if not impossible. At such times, capital infusion by promoters would not only assuage creditors’ fears, but would also signal the former’s resilience and commitment to the business. This is what sets promoter-shareholders apart from other shareholders and, in turn, sets corporates that survive troughs in business cycles apart from those that fail!
If that is how it works with non-bank corporates, the owner-lender-asymmetry shifts to a whole new level in the context of banks where the lenders are depositors who entrust their hard-earned savings to the bank. This is because the core business model of traditional banking is characterised by a misalignment of assumptions regarding risk and reward. Depositors lend their money to banks in return for virtually risk-free returns; banks, in turn, lend this debt capital to businesses (risky) in order to earn a spread—the lifeline of the business of banking.
But risk is an integral part of business and banks are no exception to this. Consequently, any lending, despite the best due diligence and credit appraisal can, on occasion, become a non-performing asset (NPA). So long as a bank’s NPAs are well below its profit, depositors might not even be aware of its existence. However, in a scenario where there is greater competition and the macroeconomic situation turns adverse, NPAs can increase dramatically, raising not only the ratio of NPAs to profits, but also the quantum of provisions and write-offs. This could dent the current year profits and worse, could eat into past year reserves.
As long as the market and depositors see this as a temporary phenomenon, the cushion provided by past profits will suffice and will not result in panic. But at the first overt sign of trouble, depositors, especially CASA (current account and savings accounts) depositors, may rush to withdraw their money, leading to a run on the bank. At such times, it is only the comfort provided by large equity or owned funds that can quell the panic.
Today, the scale of provisioning and write-offs by Indian banks has eaten into past profits and reduced the equity base of many banks to dangerously low levels, thereby endangering the fine balance between the ratio of their debt and equity. The liquidity squeeze experienced by many small and medium sized firms, following demonetisation is likely to result in an increase in NPAs in this sector as well, skewing the ratio between banks’ debt and equity capital even further. RBI’s latest Financial Stability Report (December 2016) holds out the grim prospect of NPAs rising to 9.8% and further to 10.1% by March 2018.
In such a scenario, the danger of a run on banks is never far from the surface. Today, the government ownership of PSBs ensures depositors have faith in banks regardless of whether their equity capital is eroded or not. Underlying this faith (misplaced) is the confidence that government will make good any loss to depositors. But as the share of government shareholding in PSBs comes down—as it must in the coming years—this faith can no longer be taken for granted. Equity infusion alone will prevent a panic and possible run on the banking system.
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A large deposit base will help banks increase their business. This only underlines the urgent need for increased capital and the infusion of capital by the dominant shareholder, the government.
S Veena Iyer and NR Bhusnurmath are finance professors, MDI Gurgaon. Views are personal