Recap plan to help banks absorb losses on NPAs. But will it reform banking?

According to a few senior top bank officials, the recapitalisation plan means banks now have more cash in their pockets in order to provide for more loans. Banks can sell off their large non-performing loans absorbing the losses as more capital would mean they have enough capacity to take hair-cuts and let go of bad loans decaying their balance sheets. Also, over the medium term, credit growth may come back into the system in a few quarters.

While the contours of the recapitalization bonds are not out, Finance Minister Arun Jaitley hinted that the bonds could be sold directly to the banks, with the proceeds returned as equity. Effectively, this would be financial engineering which would mean converting banks' excess liquidity (in the form of deposits, especially that post demonetisation) into equity.

Therefore, this may also push the lagging credit growth forward as banks can now lend the money that was earlier restricted to be used. Given the credit demand in the system and excess capacities built on large projects, this capital may push the existing capacities to be utlilised and the lending by banks could kickstart over the medium term in the next few quarters.

In the 1990s, a similar move was taken by the government which issued recapitalisation bonds to the banks to tide over the bad loan mess. These bonds were non-tradeable at first, didn’t qualify for SLR (statutory liquidity ratio) as is allowed under government bonds and later were either converted to equity or made into perpetual bonds.

The move did help the banking sector on a temporary basis; the bad loan mess was not eradicated from its roots. Experts suggest that more banking reforms along with this recapitalization plan may serve a larger purpose.

Further, the cost of issuing these recapitalisation bonds would be in the form of annual interest payment of Rs 8,000-9,000 crore, Chief Economic Adviser to the government of India Arvind Subramanian tweeted.

Apart from this impact on the fiscal deficit, anything further will only be ascertained once the fine print of the plan is announced.

The fiscal deficit is essentially: all inflows minus all outflows except the part that involves borrowing.

During the announcement, Jaitley pointed out that such a recapitalization at a global level is not part of the fiscal numbers, while in India it is accounted under the fiscal deficit numbers and hence can be impacted.

As per a Fitch Ratings report, with the government’s target to reduce the central government fiscal deficit to 3.2 percent of GDP this year, the recapitalisation plans could make this target more difficult to achieve if recapitalisation bonds are to be issued by the central government, which might mean expenditure cuts elsewhere.

It added that the government's plan is to provide capital to all banks that need it, which carries some risk of encouraging a moral hazard. However, the size of capital allocations is to be determined by performance, which suggests the largest share will go to stronger banks, while some banks - particularly smaller, struggling ones - could still be swept up into the government's consolidation agenda.

It remains to be seen if the recapitalization would be a temporary fix or a jackpot for the Modi government as it prepares for the elections in 2019.