One of the examples of Big Government I have in my book India’s Big Government is that of government owned public sector banks. (The good news is that the book is available at a huge discount on Amazon till Friday, 27th October. The Kindle version is going at Rs 199, against a maximum retail price of Rs 749, and the paperback is going at Rs 499, against a maximum retail price of Rs 999).
When I wrote the book, the Indian government owned 27 public sector banks. As of April 1, 2017, the Bhartiya Mahila Bank and the five associate banks of State Bank of India, were merged with the State Bank of India. Due to this merger, the number of government owned banks fell to 21. This merger has pulled down the overall performance of the State Bank of India and is just a way of sweeping problems under the carpet. Over the years, the government plans to use mergers to reduce the number of banks it owns to anywhere between ten to fifteen. This as I have said in the past is a bad idea.
Yesterday afternoon, the finance ministry announced a plan to invest more capital in public sector banks, which are saddled with a massive amount of bad loans and restructured loans. The government plans to put in Rs 2,11,000 crore over the next two years, “with maximum allocation in the current year”.
Where will this money come from? Rs 18,139 crore has been allocated from the current financial year’s budget. Banks are expected to raise capital by issuing new shares. This is expected to raise around Rs 58,000 crore.
This leaves us with around Rs 1,35,000 crore. Where will this money come from? This money is expected to come in through recapitalisation bonds. How will this work? The government hasn’t specified the details of how these bonds will be issued. (This makes me wonder as to why have a press conference in the first place, when the most important part of the plan, has not been decided on).
From what I could gather speaking to people who understand such things, this is how it is supposed to work. The banks have a lot of liquidity because of all the money that has come in because of demonetisation. A part of these deposits will be used by public sector banks to buy recapitalisation bonds issued by the government.
The money that the government thus gets will be used to buy fresh shares that the banks will issue. Thus, the banks will be recapitalised.
Now on the face of it, this sounds like a brilliant plan, where money is moved from one part of the balance sheet to another and a huge problem is solved. But is it as simple as that?
a) By issuing recapitalisation bonds the debt of the government will go up. Over and above this, interest will have to be paid on these bonds. Both the debt and the interest will add to the fiscal deficit of the government.
b) Given that the debt of the government will go up, this would mean that the taxpayers will ultimately pick up the tab because the debt will have to be repaid. It makes sense to always remember that there is no free lunch in economics. The corollary to this is that there is no free lunch especially when something feels like a free lunch. Of course, the taxpayers aren’t organised and hence, they are unlikely to protest. And given that they finance all bailouts.
c) It remains to be seen what the banks do with this extra capital. Will they use it to write off restructured loans of corporates? Will this dull their enthusiasm (not that they had enough of it in the first place) to recover bad loans? As the situation changes, so will the behaviour of bankers.
This will also bring to the fore the issue of moral hazard. And what is moral hazard? As Mohamed A El-Erian writes in The Only Game in Town: “[It] is the inclination to take more risk because of the perceived backing of an effective and decisive insurance mechanism.” If the government bails them around this time around, the banks know that they can count on the government bailing them out the next time around as well. And this means that they can follow fairly loose standards of lending, in order to lend money quickly.
d) As I keep saying, bank lending among other things is also a function of whether there is demand for such lending. The public sector banks have gone slow on lending to corporates (in fact they have contracted their loan book) because of a lack of capital. Or so we are told. But this lack of capital doesn’t seem to have hindered their lending to the retail segment. Now that they will have access to more capital, will this reluctance to lend to corporates go away? I am not so sure.
e) Also, some of the banks are in such a bad state, that they really don’t deserve this capital. They shouldn’t be in the business of banking in the first place. Take a look at Table 1. Table 1, lists out the bad loans ratio of all the public sector banks. Bad loans are essentially loans in which the repayment from a borrower has been due for 90 days or more.
Table 1:
| Name of the bank | Bad loans ratio (in per cent) |
|---|---|
| IDBI Bank | 24.11 |
| Indian Overseas Bank | 23.6 |
| UCO Bank | 19.87 |
| Bank of Maharashtra | 18.59 |
| Central Bank of India | 18.23 |
| Dena Bank | 17.37 |
| United Bank of India | 17.17 |
| Corporation Bank | 15.49 |
| Oriental Bank of Commerce | 14.83 |
| Allahabad Bank | 13.85 |
| Punjab National Bank | 13.66 |
| Andhra Bank | 13.33 |
| Bank of India | 13.05 |
| Union Bank of India | 12.63 |
| Bank of Baroda | 11.4 |
| Punjab and Sind Bank | 11.33 |
| Canara Bank | 10.56 |
| State Bank of India | 9.97 |
| Syndicate Bank | 9.96 |
| Vijaya Bank | 7.3 |
| Indian bank | 7.21 |
Source: www.careratings.com
As can be seen from Table 1, only two public sector banks have a bad loans ratio significantly lower than 10 per cent (Actually its four, but State Bank of India and Syndicate Bank are very close to 10 per cent).
Eight out of the 21 banks have a bad loans ratio of greater than 15 per cent. This basically means that out of every Rs 100 of lending carried out by these banks, at least Rs 15 is no longer being repaid.
Some of these banks with extremely high bad loans are way too small to make any difference in the overall lending carried out by banks. Take a look at Table 2.
Table 2:
| Name of the Bank | Total advances as a percentage of gross advances of banks (as on March 31, 2017) | Bad loans rate (as on June 30, 2017) |
|---|---|---|
| United Bank of India | 0.82% | 17.17% |
| Dena Bank | 0.90% | 17.37% |
| Bank of Maharashtra | 1.18% | 18.59% |
| UCO Bank | 1.48% | 19.87% |
| Central Bank of India | 1.73% | 18.23% |
| Indian Overseas Bank | 1.74% | 23.60% |
Source: Author calculations on Indian Banks’ Association data and www.careratings.com
These public sector banks have now reached a stage wherein there is no point in the government trying to spend time and money, in reviving them. It simply makes more sense to shut them down and sell their assets piece by piece or to sell them, lock, stock and barrel, if any of the bigger private banks or any other private firms, are willing to buy them. But what the government is doing instead is using taxpayer money to maintain its control over banks.
f) Also, recapitalising banks does not take care of the basic problem at the heart of public sector banks, which is that they are public sector banks. Allow me to explain. Let’s take the example of the State Bank of India, the largest public sector banks. As of June 30, 2017, the bad loans ratio of the bank when it came to retail lending was 1.56 per cent. At the same time, the bad loans ratio when it came to corporate lending was 18.61per cent.This basically means that State Bank of India, does a terrific job at retail lending but really screws up when it comes to lending to industry. What is happening here? Thomas Sowell, an American economist turned political philosopher, discusses the concept of separation of knowledge and power, in his book Wealth, Poverty and Politics.
How does it apply in this context? In public sector banks, managers who have the knowledge to take the right decisions may not always have the power to do so. Take the case of retail lending. The manager looks at the ability of the borrower to repay a loan, and then decides to commission or not commission one. This explains why the bad loans ratio in case of retail lending is as low as 1.56 per cent (in fact, it was just 0.55 per cent before the merger). A proper process to give a loan is being followed in this case.
But when it comes to lending to corporates, there are people out there (or at least used to be) who are trying to influence the manager’s decision; from bureaucrats to ministers to politicians. In this scenario, the manager ends up giving out loans even to those corporates who do not have the wherewithal to repay it.
The separation between knowledge and power has led to a situation where bank loans were given to many crony capitalists who have defaulted, and what we are seeing now is a fall out of that. In many cases, the corporates have simply siphoned off the loan amounts by over declaring the cost of the projects they borrowed against.
Of course, as long public sector banks continue to remain public sector banks, this risk will remain. But this government (and the ones before it) likes the idea of owning banks, and because it gives some relevance to ministers and bureaucrats.
Also, the employee unions of public sector banks have a huge nuisance value. No government has had the balls to take them on, in the past. Neither does this one. And this basically means that taxpayers will have to continue rescuing the public sector banks.
The column originally appeared on Equitymaster The column originally appeared on Equitymaster with a different headline on October 25, 2017.