On Sunday, November 23, 2008, the United States government, acting in concert with the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation, rescued Citigroup by guaranteeing to shoulder the major part of the losses on $306 billion of identified toxic loans in the books of Citigroup. Citigroup was required to absorb the first 10% of the losses (in addition to existing reserves) and the balance losses were to be shared 10% by Citigroup and 90% by the government. As consideration for absorbing the losses, the government got $7 billion of preferred shares carrying 8% dividend and warrants valid for 10 years to acquire $2.7 billion of equity shares at a strike price which was the trailing average price for 20 days ending on November 21, 2008; in addition, the government agreed to inject another $20 billion in preferred shares. There were restrictions put on Citigroup, including on the dividends it could pay to its shareholders. This was shortly after the government had pumped in $25 billion into Citigroup following its $21 billion of losses in the preceding four quarters which had hammered down the Citi share price to one-third of what it was just a year earlier. Citigroup shares jumped 65% when markets came live next morning. The government, with its guarantee, had rescued the bank by providing the capital adequacy required for the bank to continue operating. Something similar can be a way out for the rescue of public sector banks (PSU) that have credible turnaround plans and management. CRISIL estimates that banks would have to take losses of Rs 240,000 crore on just 50 top bad accounts which have exposure of Rs 400,000 crore.
The government does not have the wherewithal to pump in cash into the banks on a scale of this magnitude. At the same time, without taking on those losses, there is monstrous waste in a capital-scarce country of underutilised assets underlying these loans which can then be put to optimum use. Removing the overhang of capital inadequacy from write-downs will enable banks to start lending again to support growth. A central government guarantee for PSU banks for a substantial portion of the losses on an identified pool of loans will optically be more acceptable in terms of fiscal constraints. Banks must be forced to absorb a portion of the losses to encourage maximum recovery on that pool of loans. The guarantee should cost the PSU bank an annual charge (of, say, 1%) and the government gets the right to subscribe to a certain percentage of equity of the bank at the current share price; the banks would have to submit a plan for phasing out the guarantee, which should be available for no more than 10 years, including by issuing additional shares to non-government shareholders. The guarantee would avoid immediate dilution for the banks at the below-book-value currently prevailing resulting in improvement in the share price and the banks can raise funds a year or two into their turnaround plan at a much higher value. Simultaneously, RBI guidelines for sale of stressed loans should be made more practical. The guidelines should require banks to write down capital of the stressed company before any debt-for-equity swap.
RBI should encourage those banks to take haircuts, sell loans, convert debt into equity of the stressed companies after writing down their existing equity, change existing managements of the defaulting companies, hire new managers for those companies and align their economic incentives to those of the bank. For avoiding such catastrophic NPA issues in the future, the government and RBI must work together to focus on governance at the banks, and improve credit appraisal, monitoring and recovery processes. PSU banks must be held accountable for their own decisions and not be absolved for naively joining consortia with a lead bank, relying on appraisals done by agencies such as SBI Capital Markets, which collected a fee for those appraisals, took no risk and whose interests were not aligned with those of banks. Additionally, the government as owner must avoid using banks for policy loans, stop giving loan-growth targets to banks but instead have targets of profits, profitability and net NPAs. Most importantly, as part of good governance at the banks, it should set in place in each bank succession plans, give long tenor to CEOs, put in competent and honest directors and demand as shareholder improved performance from those boards and managements. The NPA problem at the banks is very formidable and there are no easy solutions. Prime minister Modi’s government has demonstrated the willingness to take hard decision in the interests of the country. Rescuing public sector banks and setting right the financial system requires these tough decisions.
Founder and former MD, CRISIL