The Indian Banking system has been trying to resolve its crisis of bad loans. In particular, public sector banks (PSB) have been struggling with their NPAs (non-performing assets).
There have been ongoing efforts since 2015 to address this issue. The RBI mandated Asset Quality Reviews (AQRs) that brought more transparency in determining the quality of loans. Following this, banks were expected to create provisions for their bad loans. Additionally, amendments to the Insolvency & Bankruptcy Code (IBC) and the intervention of the NCLT (National Company Law Tribunal) has sped up the loan recovery process.
However, banks remain stressed and have been unable to boost their interest inflows and grow. A healthy banking system is necessary for a healthy economy.
A Vicious Cycle
Banks are trapped in a vicious cycle. The NPA crisis rose from incorrect capital allocation. When a borrower defaults, the bank’s capital ratios take a hit. Subsequently, banks become fearful of taking on new loans because a default will worsen their position. By refusing additional capital, the ratios decline further adding more stress to balance sheets. On the other hand, writing off NPAs puts off new investors thereby reducing capital inflows.
One of the ways to get out of this mess is to infuse capital into banks. The government’s proposition to recapitalize banks with Rs. 211,000 Crores doubles up as a reform initiative. Capital will be allocated based on merit, prioritizing banks who have polished their balance sheets by cleaning up their NPAs. This initiative forces banks to take real losses by auctioning off collateral, seizing assets, and absorbing losses. Thus, the idea is not to bail out banks, but to help better capital ratios and raise fresh capital. This will be structured using recapitalization bonds.
The Way Forward
Now, banks must become responsible with their capital allocation. The recapitalization bonds will have to be earned. The capital infusion will enhance the balance sheets and spur growth. Simultaneously capital allocation will improve by giving banks liquidity to lend without having to compromise on the quality of borrowers. The economy as a whole will benefit from government spending through these PSBs. The fittest banks will survive. We may even see consolidation and mergers in the PSB space, resulting in healthy, stable, large, public sector banks.
Following from the capital adequacy requirements under the Basel III accord, banks’ capital was split into tier 1 and tier 2 capital. Tier 1 forms the bank’s core capital, while Tier 2 forms its supplementary capital. The instruments under Tier 2 capital are riskier as it is difficult to assess their quality and they are harder to liquidate. However, the purpose of tier 1 and tier 2 capital is to ensure that banks can absorb losses (if any) and continue functioning under periods of financial duress.
Tier 2 Capital:
In India, tier 2 capital consists of reserves and hybrid securities. Reserves are capital provisions that a bank makes. Hybrid securities carry features of both debt and equity instruments and may further be classified into upper (perpetual instruments) and lower capital (dated instruments).
General Provisions & Loss Reserves:
This reserve is created as a hedge against any unidentified losses.
A revaluation reserve is created by reassessing the value of an asset. The idea is to update the value of an asset from its historic cost to its current value. For instance, a bank may have one of its properties revalued to reflect appreciation in real estate.
Primarily this consists of perpetual cumulative preference shares (PCPS). Like AT1 instruments, these securities have no maturity. A cumulative instrument is one where payments if missed, are accrued and paid when finances permit.
Dated securities are those that have a maturity. Tier 2 Capital instruments are redeemable and may be cumulative or non-cumulative preference shares (RCPS or RNCPS). These instruments have a minimum tenor of 5 years.