Union Budget 2015: Bold steps in BFSI to ensure economic growth, says EY

Abizer DiwanjiEY

Budget 2015 is largely expected to lay the groundwork for the new government’s agenda over the next few years. Key challenge facing the new government is reviving economic growth given the fiscal responsibility frameworks. Boosting credit growth and resolving crucial issues facing the financial sector is a critical first step to ensure funding of that growth. Empirical evidence suggests that credit growth of around 20% is required to support around 7-8% GDP growth rate as there needs to be significant capacity addition or revival of existing capacities and build-up of infrastructure all of which would require bank funding.

The new government will have to acknowledge and then work towards a radical solution to the problem of rising stressed assets in the banking system, meet the significant capital requirement under Basel III for PSU banks without too much strain on the fiscal system and debottleneck stalled projects in the infrastructure sector to boost credit growth and the capex cycle. The issue of resolution of fixed assets, raising capital for banks as well as governance changes are linked and the key to implementation is government divestment at the BIC level for banks.

Resolving the issue of stressed assetsBanking system has been reeling under the increasing burden of stressed assets over past few years. Stressed assets have increased to 10.7% of total advances as of September 2014. The problem is more severe in PSU banks with level of stressed assets at 12.9% of total advances. There is a need for a specialized ARC structure to aggregate loan exposures of a distressed borrower in different banks to effectively workout a resolution strategy after debt aggregation. Banks would then be able to focus on growth of credit book as against dealing with legacy stressed debt exposures.

In the forthcoming budget, the government could consider announcing the establishment of a specialized ARC called NAMCO (National Asset Management Company) and set aside budgetary allocation for the initial equity capital infusion for such an entity. This model has been successfully applied by several other large Asian economies to resolve the NPA issue.

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Abizer Diwanji

Partner and National Leader - Financial Services|EY

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Table 1: International Comparisons of Specialized ARC Structures

An Centralised reconstruction company would take on a channelizing role to further down sell assets to ARCs or growth capital providers without any inter creditor issues. Once refinanced, banks would provide funding to these revived projects.

India has tried this structure earlier through the Stressed Assets Stabilisation Fund (SASF) floated by IDBI and hence, with renewed resolve and appropriate legislative back up, this model may be a success.

In addition to right sizing banks’ balance sheets, there could then be a free flow of external capital into these organisations. The Reserve Bank may be directed to issue credit assessment norms with stricter capital requirements for non-compliances to ensure that the probability of such problems recurring is minimised. Europe has introduced capital allocation based on information assessed in a credit stress test. A similar model could be adapted for India. Given its growth potential, revival of well-funded and restructured assets could yield unprecedented results.

Capitalization of PSU banks

Basel III implementation would require significant capital infusion particularly in PSU banks given that minimum core equity requirement (including Capital Conservation Buffer) will rise gradually to 8% by FY19. It is estimated that PSU banks would require INR 1.6 trillion to 2.2 trillion in equity infusion to bridge Basel III capital shortfall. Government will have to infuse over INR 830 billion by FY19 to maintain government majority stake in PSU banks which will put significant pressure on the fiscal situation.

Bank Investment Company (BIC) structure as proposed by the PJ Nayak Committee will enable the government to meet PSU banks’ capital infusion requirements. BIC structure could act as an investment management company to hold government stake in PSU banks and government would be able to raise capital while retaining the PSU status for these entities. BIC model will transform the role of the government from sovereign owner with control over bank management to sovereign investor focused on long term financial returns. Also a governance structure as envisaged by the PJ Nayak Committee can be implemented. With the right sizing of balance sheets, external capital infusion and desired governance structure PSU banks would be able to implement the requisite transformations that they seek in various areas.

BIC structure should attract stable capital from long term investors such as sovereign wealth funds, insurance companies, pension funds etc. The pool of capital that is raised in the BIC would then be allocated to banks who have the potential to provide the maximum value to the system and it may also lead to much needed consolidation in due course.Table 2 gives a synopsis of the quantum of investments a BIC could get in to fund Indian Banks growth.

Table 2: BIC Structure Details

India has the ability to raise in excess of INR 1 Trillion of capital through the BIC route as long as issues around cleaning up banks and laying the path for governance are laid out. Market capitalisations are unlikely to be impacted as the markets seem to have discounted the stressed assets valuations already. In fact, quantifying the exposure may result in better valuations.

Increasing the pie of financial savings

Savings rate has been falling consistently over past few years from a high of 36.8% of GDP in FY08 to 30.1% in FY13 on account of high inflation and increasing public expenditure. Also household savings, which constitutes bulk of the domestic savings, has seen a significant shift from financial savings to savings in physical assets (mainly gold and property which are not productive.

To encourage increase in financial savings, there needs to be increase in post tax yield to match inflation and increase efforts towards reducing the cash component in the Economy. The value of currency in circulation as a % of GDP is much higher than even other emerging markets (see chart below).

 Financial inclusion agenda received a significant boost through government’s initiative of Pradhan Mantri Jan Dhan Yojana (PMJDY). Nearly 125 million accounts have been opened under PMJDY until end of Jan ‘15. However, around 84 million accounts have zero balance. Migrating government subsidies (DBT) to electronic payments mode alongwith leveraging technology for payments could give a huge boost to activating dormant accounts under PMJDY and promoting financial savings.

Also increasing tax exemption for collective saving schemes (Equity and Debt mutual funds, REITS, infra funds) could discourage shift towards physical assets (gold or property) and enable more professional investment and wealth management options for creation of formal wealth for the Indian middle class.

Government has already addressed the long standing demand of capital starved insurance industry for liberalization of Foreign Direct Investment (FDI) which would result in well capitalised insurance companies to enable increase in penetration on the insurance and pensions side.

All in all, India needs bold steps in the financial sector to ensure that the growth in the Economy could be funded by well capitalised banks and garnering of domestic savings.

The author is Partner and National Leader - Financial Services at EY

(Views are personal)