The mess in public sector banks will not be easy to sort out

The finance minister Arun Jaitley met the chiefs of public sector banks yesterday for a quarterly review of performance. Media reports suggest that among other things the banks were also asked to cut interest rates on their loans.
The Reserve Bank of India (RBI) has cut the repo rate by 50 basis points to 7.5% during the course of this year. Repo rate is the rate at which the RBI lends to banks. But banks haven’t passed on this cut to their end consumers.
There are multiple reasons for the same. Typically when the RBI increases the repo rate, the banks match the increase very quickly. But the same thing is not seen when it comes to a scenario where the RBI cuts the repo rate. Banks are normally very slow to pass on cuts to consumers.
Crisil Research points out in a research note: “Lending rates show upward flexibility during monetary tightening but downward rigidity during easing. Between 2002 and 2004, while the policy rate declined by 200 basis points, lending rates dropped by just 90-100 basis points. Conversely, in 2011-12, when the policy rate rose by 170 basis points, lending rates surged 150 basis points.”
But there is a little more to it than just this. The balance sheets of public sector banks are in a big mess. As thelatest financial stability report released by the RBI 
in December 2014 points out: “PSBs [public sector banks] continued to record the highest level of stressed advances at 12.9 per cent of their total advances in September 2014 followed by private sector banks at 4.4 per cent.”
What this clearly shows is that public sector banks are not in great shape. The stressed asset ratio is the sum of gross non performing assets plus restructured loans divided by the total assets held by the Indian banking system. The borrower has either stopped to repay this loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate.
What this means in simple English is that for every Rs 100 given by Indian banks as a loan (a loan is an asset for a bank) nearly Rs 10.7 is in shaky territory. For public sector banks this number is even higher at Rs 12.9.
Also, as the following table from 
Credit Suisse shows, 46% of public sector banks have a tier I capital of less than 8% and un-provided problem loans greater than 100% of their networth. 

62% of PSU banks have Tier-I < 9% and
Un-provided problem loans > 100%

Source: Company data, Credit Suisse estimates

What this clearly tells you is that banks many public sector banks do not have enough money to cover their losses. The public sector banks are hoping to recover some of these losses by cutting their deposit rates but staying put on their lending rates. And this leads to a situation where even though the RBI has cut the repo rate once, it hasn’t had much impact on the lending rates of banks.
Further, banks do not have enough capital going around. Take the case of Tier I capital mentioned
earlier. It is essentially sort of permanent capital that the bank has access to andincludes equity capital and disclosed reserves.As the RBI master circular on this points out: “Tier I capital consists mainly of share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover losses.”

As the following table shows the average tier I capital of public sector banks is less than 8%. While this is the more than 6% tier I capital that banks are required to maintain under current norms, it is very close to the 7% tier I capital that banks will have to maintain under the Basel III norms, which need to be fully implemented by March 31, 2018.

Average Tier-I for PSU banks is less than 8%

This lack of capital has and will continue to constrain the ability of the public sector banks to lend and keep growing. The PJ Nayak committee report released in May 2014, estimated that between January 2014 and March 2018 “public sector banks would need Rs. 5.87 lakh crores of tier-I capital.”
The report further points out that “assuming that the Government puts in 60 per cent (though it will be challenging to raise the remaining 40 per cent from the capital markets), the Government would need to invest over Rs. 3.50 lakh crores.” In the next financial year’s budget the finance minister Arun Jaitley has committed just Rs 7,940 crore towards this. 
As analysts Ashish Gupta, Prashant Kumar and Kush Shah of Credit Suisse point out in a recent research note: “The amount allocated is almost the same as our estimate of total dividend likely to be paid by all PSU banks to the government in FY16. This indicates that government capital infusion going forward could be a function of only the profit generation ability of PSU banks.”
Also, by allocating a very small amount to towards public sector banks recapitalization, the message that the government seems to be giving the banks is that they are on their own. This in a way is good, given that the government clearly is not in a position to commit the kind of money required to recapitalize the public sector banks.
Nevertheless, many public sector banks are not in a position to raise money on their own, given the mess their balance sheet is in. As the Credit Suisse analysts point out: “Smaller/weaker PSU banks with limited ability to raise capital from markets will be worst affected as there is very little likelihood of getting capital next year as well.”
So what is the way out? The only way out for the government is to sell off the weaker banks. There is no reason that the government of India should be running more than 20 banks. It simply doesn’t make any sense. Mergers of the weaker banks with the stronger ones is not a feasible option for the simple reason that it will tend to pull down the well performing banks as well. 
Of course politically this will be difficult to implement. But that is the kind of strong governance that Narendra Modi promised the people of this country. It is now time to deliver.

The column originally appeared on The Daily Reckoning on Mar 12, 2015