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The Economic Survey 2021, released on January 29 ahead of Budget 2021, has called for adequate capitalisation of public sector banks. If capital is not provided, lenders may resort to risk-shifting, it said. In turn, impacting the real economic recovery.
“Under-capitalised banks may again resort to risk-shifting and zombie lending, thereby severely exacerbating the problem,” the survey said.
“The adverse impact could then spill over to the real economy through good borrowers and projects being denied credit. The resultant drop in the investment rate of the economy could then lead to the slowdown of economic growth,” the survey said.
This warning is significant since the credit growth has plunged to record low levels in the recent months on account of a range of factors including general economic slowdown and muted demand. Also, banks have been highly risk averse to lend to smaller firms due to high risk perception.
The public sector banks (PSBs) accounts for 60 percent of the assets in the Indian banking system and are under government ownership. These banks also account for over 90 percent of the stressed assets in the banking system.
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Banks require capital to meet the mandatory reserve requirements laid out by the Reserve Bank of India (RBI), make provisions for bad loans and kick-start the lending cycle when demand revives in the economy. In the last union budget, the FM didn’t allocate any fresh capital for PSBs. Sitharaman said over years, the government has infused Rs 3.5 lakh crore capital in PSBs and asked banks to move to the capital market for fundraising purposes.
In August 2020, rating agency Moody’s had said that India’s public sector banks would require upto Rs 2 lakh crore over the next two years. About half of it will be used to build provisions on bad loans, the agency had said.
The survey cautioned the government that inadequate capitalisation of banks could have a serious impact on the real economy as credit flow dries up to productive sectors. After the AQR initiated in 2015-16, the inability of banks to raise capital resulted in reduced lending, the Economic Survey said.
Explaining the economic rationale behind the relationship between reduction in capital and increased risky lending, the survey said in an already-stressed banking sector, the second wave of under-capitalisation caused by the AQR created perverse incentives to lend even more to the unproductive zombie borrowers.
“Banks’ tightening of credit supply negatively impacts healthy borrowers as it forces firms to cut down on their investments and capital expenditures. Thus, the likelihood of stalling of ongoing projects increases,” the survey said.
It further noted that there was a significant increase in the value of stalled projects following the AQR for firms exposed to banks affected by the AQR when compared to firms that engaged with unaffected banks.
“These firms became financially constrained and reduced their capital expenditures, leading to ongoing projects being stalled,” said the survey. “In terms of lending, being undercapitalised, banks reduced lending to good borrowers while increasing lending to zombie borrowers. For firms, the reduction in the supply of bank credit reduced their ability to invest,” the survey said.
These comments in the Economic survey are significant considering that there is a widespread expectation that FM Sitharaman will announce capital infusion in the Budget 2021. About 60 percent of the assets in the banking industry is under the control of the government through state-owned banks.