Bank credit to the economy has slowed down. In 2016-17 (year-on-year as at September), overall bank credit grew at 4.2%, compared to 11.5% in 2015-16. Credit to industry has been stagnant for the last two years. It contracted by -0.4% in 2016-17, and grew only at 0.8% in the previous year. For an economy where banks account for more than 65% of the domestic credit, this is bad news. A major reason for the slowdown in credit is the stressed assets of banks, mainly Public Sector Banks (PSBs). Stressed assets put a strain on the capital adequacy of banks and affect their ability to lend.
In October 2017, the government announced a recapitalisation package of Rs. 2.11 trillion for PSBs. Analysts claim (link, link, link) that this recapitalisation will provide the PSBs with growth capital. They will be able to start lending again, giving a much-needed boost to the economy. In this article, we explore five questions that we think need to be answered in order to evaluate the veracity of this claim. These are:
What is the impact of stressed assets on PSBs'
How much capital do PSBs need to meet regulatory capital standards?
When will PSBs have growth capital?
How certain is the recapitalisation package?
Will the recapitalisation package provide growth capital?
Most listed entities, including PSBs make detailed presentations on their performance to analysts every time they disclose their quarterly or annual results. These presentations, where PSBs disclose details about their business prospects, profitability, asset quality and capital adequacy, are available on their respective websites. For our analysis, we use information disclosed by 21 PSBs in their analyst presentations for the quarter ending June 2017.
Q1. What is the impact of stressed assets on PSBs' capital?
When a bank provides for losses against stressed assets, its Tier I capital gets affected. This is because Tier II capital is often in the form of bonds issued to investors, which the bank cannot default on. Unless specific loan loss reserves have been created as part of Tier II capital, any additional provision reduce the bank's Tier I capital.
Table 1 shows the stressed asset and capital position of PSBs as at June 2017. PSBs held a total capital of Rs. 7.2 trillion. Out of this, Rs. 5.6 trillion was Tier I capital. Against this stock of Tier I capital, PSBs will face additional provisioning requirements from two sources: (1) their current stock of stressed assets, and (2) any future addition to stressed assets.
|Table 1: PSB asset quality and capital adequacy, June 2017|
|Value (Rs. trillion)||As % of gross advances|
|Restructured assets classified standard (2)||1.65||2.87|
|Total stressed assets (1+2)||8.97||15.64|
|Stressed assets requiring provisions (2+3)||5.80||10.11|
|Value (Rs. trillion)||As % of risk weighted assets|
|Risk weighted assets (RWA)||58.97|
|Tier I capital||5.59||9.49|
|Tier II capital||1.58||2.73|
|Source: June 2017 Analysts' presentations of Public Sector Banks|
In June 2017, the stock of stressed assets at PSBs was Rs. 8.9 trillion. Of this the banks had not provided for Rs. 5.8 trillion. The provisioning requirement for these assets will depend on expected recovery rates. Table 2a shows this requirement under three scenarios of recovery rates, ranging from 20% to 40%. It shows that if banks expect to recover Rs. 20 for every Rs. 100 of their portfolio of stressed assets, they will need to make additional provisions of Rs. 4 trillion. If they expect to recover Rs. 40 for every Rs. 100, they will need to make additional provisions of Rs. 2.2 trillion.
|Expected recovery rate|
|Additional provision required (Rs. trillion)|
|    For NPAs (A)||1.22||1.95||2.68|
|    For Restructured assets (B)||0.99||1.15||1.32|
|    Total additional provision (C) = (A) + (B)||2.21||3.10||4.0|
|Source: Authors' estimates.|
The important question here is: what is a plausible recovery rate for the current stock of stressed assets of the PSBs? Around 70% of their stressed assets are from loans to the corporate sector. Many of these loans have seen multiple attempts at restructuring under the 5/25, Corporate Debt Restructuring (CDR), Strategic Debt Restructuring (SDR) and S4A schemes initiated by the Reserve Bank of India. The companies to whom these loans have been made are distressed, and have remained unresolved for several years. For most of these cases, even a recovery rate of 20-30% seems optimistic.
It is worth mentioning here that the resolution of many of these distressed companies will be under the Insolvency and Bankruptcy Code, 2016 (IBC). Till 8th November 2017, 391 IBC cases had been admitted at the National Company Law Tribunal (NCLT). Data on bank borrowings is available for 150 of these. The banking sector exposure to these companies is around Rs. 2 trillion, and a large chunk of it is in the PSBs. Even assuming that banks have already made 50% provisions against these loans, around Rs. 1 trillion still needs to be provided for. If the IBC results in a liquidation outcome for these companies, the recovery rates may be even lower than the anticipated 20-30% and hence the provisioning requirement will be higher.
Addition to the existing stock of stressed assets is also highly likely. There is trouble brewing in the Telecom sector and there are reports that RBI has identified a new list of 40 large companies for referral to the IBC by December 2017. PSBs will face further provisioning requirement for these cases.
Table 2b shows the impact of the existing stock of stressed assets on the Tier I capital position of the PSBs.
Additional provisions of Rs. 3.1 trillion (at a recovery rate of 30%, from Table 2a) will deplete PSBs' Tier I capital to Rs. 2.49 trillion. This will bring their Tier I Capital Adequacy Ratio (CAR) to 4.2%, which is below the CAR requirement imposed by regulatory standards.
|Expected recovery rate|
|Capital gap (Rs. trillion)|
|    Current Tier I (D)||5.59||5.59||5.59|
|    Tier I after additional provision (E) = (D) - (C)||3.38||2.49||1.59|
|    Capital required for Tier CAR = 9% (F)||5.31||5.31||5.31|
|    Capital shortfall (G) = (F) - (E)||1.93||2.82||3.72|
|Source: Authors' estimates.|
Q2. How much capital do PSBs need to meet regulatory capital requirements?
Table 2b shows the amount of capital that is needed to bring the PSBs to a Tier I CAR of 9%, after making provisions for the existing stock of stressed assets. This is just enough to fill the current capital shortfall. It does not account for any further increase in stressed assets. It also does not leave any headroom for incremental lending.
At an expected recovery rate of 30% for the existing stressed assets, PSBs will require Rs. 2.82 trillion of additional capital to get to a Tier I CAR of 9%. If the recovery rate falls to 20%, the additional capital required will increase to Rs. 3.72 trillion.
Every 1% increase in the stressed asset portfolio of PSBs will create an additional capital requirement of Rs. 0.4 trillion, at an expected recovery rate of 30%.
Q3. When will PSBs have growth capital?
PSBs require capital to: (1) fill the gap created by their existing stock of stressed assets, (2) deal with any future addition to their stressed asset portfolio, and (3) support growth in credit. The capital required for growth in credit has to be over and above what the banks need to deal with their stressed assets and to maintain the regulatory capital standards.
The stressed assets of the PSBs are currently at 15.6% of their gross advances. Even if we assume that this does not increase beyond 18%, the capital required only to deal with current and future stressed assets will be Rs. 3.4 trillion at a recovery rate of 30%. To achieve a 10% annual growth in advances over the next two years, PSBs will require additional capital of Rs. 1.1 trillion (at a CAR of 9%) over and above the requirement for stressed assets.
Assuming that stressed assets at PSBs have peaked and will not impose a significant burden on future capital requirements, PSBs will require additional capital of Rs. 4.5 trillion to grow at 10% in the next two years. At this level, they will be able to deal with their stressed assets, and be able to lend again.
Q4. How certain is the recapitalisation package?
The recapitalisation package announced by the government has 3 elements:
Recapitalisation bonds of Rs. 1.35 trillion,
Budgetary allocations of Rs 0.18 trillion, under the
Indradhanush Scheme, and
Equity capital of Rs. 0.58 trillion to be raised by PSBs from the capital market.
Of the three elements of the scheme, the first two are certain. However, there are doubts about the ability of PSBs to raise Rs. 0.58 trillion from the market. A CAG report released in July 2017 reviewed the implementation of the capital infusion plan under the government's Indradhanush plan. The Indradhanush plan was initiated by the government in August 2015 to revamp PSBs. Under this plan, the government estimated that PSBs would require additional capital of Rs. 1.8 trillion till FY 2019. Of this Rs. 0.7 trillion was to come from fiscal allocations over a four-year period. PSBs were required to raise the remaining Rs. 1.1 trillion from the capital market. The CAG report found that till March 2017, PSBs had been able to raise only Rs 0.07 trillion, or 6.3% of the capital to be raised from the market.
In FY 16, the total size of the equity issuance market was Rs. 0.46 trillion. In FY 17, it is expected to be Rs. 1 trillion. Even at 2017 levels, the capital requirements of the PSBs are 60% of the entire market. The ability of all 21 PSBs to raise capital is not uniform. The PSBs that have the highest levels of stressed assets, and hence the most urgent need for additional capital, may find it the most difficult to raise capital from the market.
Rs. 1.53 trillion of the Rs. 2.11 recapitalisation plan is certain. The remaining Rs. 0.58 trillion will depend on the ability of the PSBs to successfully access the capital market.
Q5. Will the recapitalisation package provide growth capital?
As our estimates show, the recapitalisation package of Rs. 2.11 trillion is not sufficient to cover even the additional capital of Rs. 2.82 trillion required by the PSBs to provide for the existing stock of stressed assets and meet regulatory capital requirements (from Table 2b, at 30% recovery rate and 9% Tier I CAR). It does not come close to providing the PSBs with the headroom required to grow their advances.
Even at conservative estimates of growth in stressed assets, for bank advances to grow at 10% over the next two years, PSBs require Rs. 4.5 trillion of capital. This means that the government needs to provide the PSBs with a Phase II recapitalisation of Rs. 2.39 trillion, over and above the Rs. 2.11 trillion already announced in Phase I. If the PSBs fail to raise Rs. 0.58 trillion of the Phase I recapitalisation plan from the market, the Phase II requirement will increase to Rs. 2.97 trillion.
The government has announced a recapitalisation plan for PSBs. Our analysis shows that the quantum of this recapitalisation is inadequate. The capital shortfall faced by the PSBs from their stressed assets is larger than the capital infused. A second round of recapitalisation, perhaps even larger in quantum, may be required before the PSBs can revive their stressed balance sheets and start lending to the economy again.
Rajeswari Sengupta and Anjali Sharma are researchers at Indira Gandhi Institute of Development Research, Mumbai. The authors would like to thank Harsh Vardhan and Josh Felman for useful discussions.