## Thursday, October 11, 2012

### Government equity infusions into PSU banks

Harsh Vardhan's excellent blog post on this subject made me think further about the questions.

Finance policy makers in India are often proud of the fact that India has avoided a large systemic crisis in which substantial fiscal resources have been put into rescuing financial firms. I think this optimism is overstated. If we look back into the last 20 years, there has been a steady process of government money going into financial firms. On one hand, we have big events like UTI or IFCI or Indian Bank where large sums of public money were put into financial firms. Equally important is the regular flow of government money into PS Banks.

India is in the midst of a business cycle slowdown. This has come after the biggest-ever credit boom in India's history: in 2007, year-on-year growth of non-food credit was nudging 35%. As we know well, a boom in credit is followed by a boom in NPAs when a downturn comes about. We may well be at the cusp of an upsurge of NPAs. In this case, the pressure on capital in PS banks is going to be acute. If government thoughtlessly continues on the path of putting public money into PS banks then it would involve large sums of money.

As Harsh remarks, the striking feature of this annual resource flow is the way it has become commonplace. Nobody even notices this any more. In a time where government does not put equity capital into any other PSUs, the scale at which this is taking place is quite remarkable.

When the government builds a highway, the cost-benefit analysis is straightforward. Do we want to spend Rs.5000 crore in order to get a 1000 kilometre highway? A tangible result -- the highway -- is the fruit of the fiscal labour. In contrast, capital infusions into PS banks are not animated by a clear goal. What are we doing? Why is this wise? What is the cost benefit analysis? Are there other mechanisms through which the same objectives can be obtained at a lower cost? As the approach paper of the FSLRC has emphasised, perhaps the most important element of the public policy process that we require in India is clarity on objectives, and a clear demonstration that the proposed policy initiative is the best way to achieve the objective. I would classify the annual fiscal transfers to PS banks as part of the larger problem, that the edifice of Indian financial economic policy has been grounded in inadequate analysis. I am almost certain that 1000 kilometres of highway is a better use of public money than putting it into the equity capital of a PSU.

Once objectives are articulated, it becomes possible to measure the extent to which those objectives are being achieved. Evidence can be brought to bear about the extent to which the claimed objectives are being pursued. As an example, Shawn Cole did a beautiful paper which demonstrates the extent to which PS banks are a tool for rigging elections in India [journal link, ungated pdf]. If this is what PS banks do, are we better off if PS bank assets would decline, as a fraction of GDP?

Harsh's calculations treat one key number -- 1.1% return on assets for Indian banks as a whole -- as a given. If this number is given, the average Indian bank is not generating enough retained earnings to support growth, and then there is an inexorable need for fresh equity capital. I would attenuate this discussion in two dimensions:

• A key feature of a world where banks are required to have equity capital is that not all banks get this equity capital. Some banks do well, they build up their balance sheets, they have good prospects and are able to raise equity capital, and they are able to grow. Alongside them, weaker banks fail to grow. This is perfectly appropriate and a desirable feature of the system: a healthy banking system must be one where only some banks are able to grow. The fact that a bank with the average ROA requires capital for growth does not mean that we should be putting public money into all banks that require capital for growth. Many, many banks in India do not deserve to grow and hanging tough is the right way to deal with them. Growth is not a birthright: a bank must do well, and pass the market test, and thus earn the right to grow.
• There are many elements of banking policy which are driving down the return on assets. Easing these constraints is a better path for policy rather than putting in public money.
Banks in India are facing a combination of swelling NPAs, and difficulties in finding capital to grow. It is not fair for private banks to face competition from PS banks that get equity capital for free. I am reminded of Kingfisher. As long as Kingfisher was around, with an artificially low cost of capital, this exerted downward pressure on air fares, and hurt all healthy airlines. The exit of Kingfisher was of essence in bringing the rest of the industry back to health. This is the story of Japan's zombie firms': when failed firms were kept alive using public money for capital infusions, this infected healthy firms. Percy Mistry famously pointed out that Indian finance suffers from the presence of zombie banks', who only walk the world on the life support of public money. This is a deeper consequence of easy access to capital for public sector companies that we in India should be worrying about.

Harsh is undoubtedly right in suggesting that government should be willing to accept a reduced shareholding in PS banks while retaining control under the Bank Nationalisation Acts. But this leaves the residual question: if PS banks have a low ROA, the share price that this can support is low, if investors see no possibility of true privatisation in the years to come. The amount of equity capital which will come by going down this route is limited. The real story has got to be to ask PS banks to demonstrate that their claim on public money is backed by a good possibility of using capital better than NHAI.

Suppose we suggest that the government should be stingy in giving equity capital to PS banks. In the short term, the partial equilibrium analysis suggests that this will hold back the growth of banks and thus the size of Indian banking. We should bring two different perspectives to this. First, the very absence of free capital for PS banks will increase the profitability and thus equity capital access for private and foreign banks. The overall impact for India will thus be attenuated. In addition, it's easy for government to have entry of 20 new private banks. Suppose each is asked to bring in Rs.500 crore as equity capital. Using the rough 20x leverage that's found in Indian banking, this gives us new bank assets of 2% of GDP or Rs.2 trillion.

1. If the RoA is 1.1% and assuming leverage ~10 times on assets to equity, I would think the RoE for Govt.'s capital infusion would be around 11% which may not be great but is definitely not very bad either.

Am I missing something?

2. The point is not the returns generated but the utility of this funding. Yes Bank was the last private bank allowed with a license by the RBI. The way it has functioned since 2004 says enough of the ability and utility of private sector in the banking space.

Another problem is the clout of PSU NBFCs (the RECs and the IFCIs) and their pathetic lending practices to the un-creditworthy SEBs/similar bodies. All work with the given premise of a Govt bailout as and when required.

Another blatant misuse of growth capital is forcing LIC to fund the rights issues as and when the govt falls short. Funding PSU banks should be last on the least of a fund out there to generate returns for it's stakeholders. However things work differently in India as we have always seen.

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