Digital transformation and the paradox of financial inclusion in India

by Suyash Rai.

India has made great strides in digital technology, becoming a leading exporter of digitally delivered services to the global economy. These capabilities with computer technology fuelled hopes that digital transformation could yield gains for the Indian state that are comparable to those seen in the private sector. The `Digital Public Infrastructure (DPI)' approach, with India's Aadhaar digital ID system as a prime example, is presented as a path to higher GDP growth for developing countries. There is an emerging debate on the role of the state in shaping the development and deployment of DPIs.

Two key pillars of the Indian story with DPIs are identity services ("Aadhaar") and their impact on financial inclusion. In a new working paper, Economic development and digital transformation: Learning from the experience of Aadhaar and financial inclusion in India, I critically examine the Indian progress on financial inclusion between 2011 and 2021, revealing a paradox: while account ownership surged, account usage remained low.

The facts

The paper analyses India's performance compared to other lower middle-income and middle-income countries. The evidence shows:

• Impressive account opening: India witnessed remarkable progress in account penetration, surpassing the average improvement in middle-income countries.
• High inactivity: A significant percentage of accounts in India were inactive, far exceeding the average for middle-income countries.
• Low account usage: India lagged behind in account usage for both consumption smoothing (regular deposits and withdrawals) and digital payments, indicating a gap between account ownership and actual financial inclusion.

The role of government mandates and Aadhaar

We argue that the rapid scale of account opening was caused by a series of government and Reserve Bank of India (RBI)mandates, particularly the Pradhan Mantri Jan Dhan Yojana (PMJDY). While Aadhaar played a role, it was primarily used as a physical ID for KYC, rather than as a digital ID through e-KYC. The gains in account opening may have a lot to do with state coercion and less to do with DPI.

The primary objective driving these initiatives was to facilitate direct benefit transfers (DBT) for welfare schemes. The government's focus on DBT aimed to reduce leakages and improve attribution for its welfare programs in the eyes of voters.

Why did this approach yield disappointing results?

The paper explores several reasons for the limited account usage despite the increase in account ownership:

• The lack of a viable business model: No-frills accounts, with zero minimum balance and free transactions, are commercially unattractive for banks.
• Mismatch between the solution and the problem: The focus on account opening for DBT didn't necessarily translate into accounts that address the richness and complexity of finance for the poor, of meeting the diverse needs of users for consumption smoothing and payments.

Lessons

The top-down approach, with a readiness to utilise the coercive power of the state, has limitations. While the government achieved its objective of scaling up DBT, this came at the cost of genuine financial inclusion and limited the potential uses of Aadhaar as a DPI.

We highlight the need for a more balanced approach, considering market forces and user needs, so as to obtain better outcomes with DPIs. We stress the importance of political creativity, institutional reforms, and a broader understanding of public value, beyond narrow fiscal objectives, when designing and implementing DPIs.

We offers insights into the complexities of digital transformation and financial inclusion, challenging the simplistic narrative of Aadhaar's success. These experiences invite us to rethink the role of the state in shaping DPIs and consider alternative approaches that can truly leverage technology for inclusive and sustainable development.

Suyash Rai is a Fellow at Carnegie India and a Visiting Research Fellow at the xKDR Forum

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Bank recapitalisation: the allocation challenge

by Rajeswari Sengupta and Anjali Sharma.

The government has announced its plans to allocate the first round of recapitalisation funds to the public sector banks (PSBs). While the recapitalisation announcement was received by the market with great enthusiasm, the allocation has received mixed reviews (link, link). Nearly 60% of the Rs. 0.88 trillion being infused in the first round will go to the weakest 11 banks that are under the RBI's Prompt Corrective Action (PCA) framework. As part of the plan, IDBI Bank, the lender with the most stressed assets gets Rs. 0.10 trillion, the single largest amount. State Bank of India and Indian Bank, the relatively better performing banks, get Rs. 0.08 trillion and no allocation respectively.

In this article we look at four questions with regard to the allocation plan:

1. Is this recapitalisation adequate?

2. Why has more capital been allocated to the highly stressed banks?

3. Could the government have adopted an alternate, more growth oriented allocation strategy?

4. What objectives can recapitalisation fulfill?

Is this recapitalisation adequate?

No. The recapitalisation funds committed are far less than what the banks need.

In September 2017, the PSBs had stressed assets to the tune of Rs. 8.9 trillion. Against these, they held provisions of Rs. 3.4 trillion, which translates into a provision cover ratio (PCR) of 38%. PCR is an effective measure of what the banks expect to recover from their stressed assets. For example, if they expect to recover 40% of the value, they will provide for the remaining 60%. A PCR of 38% could mean one of two things. Either the PSBs expect to recover 62% of the value of their stressed assets, or they are under-provisioned. In an earlier article, we gave our reasons for believing that anything more than a 30% recovery rate is optimistic. Early indications from the corporate resolution plans submitted under the Insolvency and Bankruptcy Code (IBC) support this belief. Further, the true extent of PSBs' stressed advances is still not clear. Analysts are pointing out that stressed advances are set to grow further.

Given this, a 38% PCR indicates under-provisioning rather than expectations of recovery. Table 1 shows the additional provision required to increase PCR to various levels.

Table 1: Additional provision required at different levels of PCR

	T1 capital required*
For PCR 50%	1.1
For PCR 55%	1.5
For PCR 60%	1.9
For PCR 70%	2.8
Source: Authors' estimates; PSBs Q2-18 Analyst Presentations
* to maintain T1 CRAR of 9.5%.

PSBs currently have a Tier 1 capital base of Rs. 5.6 trillion. This is just adequate to meet the 9.5% Tier 1 capital adequacy requirement (CAR) imposed by RBI on the banks. This means that for every rupee of additional provision required, a rupee of Tier 1 capital will need to be infused in these banks. There is little hope that the PSBs' profits will reduce the need for recapitalisation. In the last two quarters, these banks have incurred losses, with Q2 losses being higher than that in Q1.

To reach a PCR of 70%, PSBs need to make additional provisions of Rs. 2.8 trillion. This is also the amount of additional capital they need. Since the IBC resolution process imposes a 270 day timeline, a large part of this requirement for capital will show up in PSB balance sheets in FY 18-19.

Against this, the government is committing Rs. 1.53 trillion, over two years. With this the PSBs will get to a PCR of 55%. This is low. The two year phasing, with Rs. 0.88 trillion being infused in FY 18-19 and the remaining Rs. 0.65 trillion in FY 19-20, is also a problem. It will ensure that: (1) PSBs will continue to be capital starved in FY 18-19, and (2) all the additional capital will get consumed for stress resolution, with no room left for supporting any growth in credit.

Why has more capital been allocated to the highly stressed banks?

There is no other choice. The stressed banks need additional capital today, without which their condition will worsen.

To understand this we look at bank level data. We classify the 21 PSBs into three categories, based on what their Tier 1 capital position would be if they were to increase their PCR to 70%, with no additional capital being infused.

• Category 1: Banks whose Tier 1 CAR will be at 7% or more.

  Under Basel III norms, banks need to hold Tier 1 CAR of at least 7%. RBI requires Indian banks to hold a Tier 1 CAR of 9.5% (7% Tier 1 Capital + 2.5% Capital Conservation Buffer).

• Category 2: Banks whose Tier 1 CAR will be positive but less than 7%.

We further divide category 2 banks into two sub-categories:

• Category 2a: Banks whose Tier 1 CAR will be more than 3.5% but less than 7%.
• Category 2b: Banks whose Tier 1 CAR will be between 0% and 3.5%.

Within category 2, category 2a are the relatively less stressed banks, and 2b are the more stressed ones.

• Category 3: Banks whose Tier 1 CAR will be negative.

In Table 2, we present details of the asset quality, capital adequacy and profitability of these categories as at September 2017. We also look at the additional Tier 1 capital that each of these categories needs in order to reach a PCR of 70%, while maintaining Tier 1 CAR at 9.5%.

Table 2: Category level analysis of PSBs

	Unit	Category 1	Category 2a	Category 2b	Category 3
		(T1 ≥ 7%)	(3.5% ≤T1 ≤ 7%)	(0% ≤ T1 ≤ 3.5%)	(T1 ≤ 0%)
Number of banks		2	7	8	4
Banks in RBI-PCA		-	1	6	4
Names of banks		SBI,	Vijaya Bank, BoB,	Allahabad Bank, Andhra Bank,	IDBI Bank, IOB,
		Indian Bank	Syndicate Bank,	OBC, UCO Bank, J&K Bank.	Dena Bank
			Union Bank of India,	Central Bank, Corporation Bank,	United Bank of India
			BoI, PNB, Canara Bank	Bank of Maharashtra
Sept-17 performance
Stressed advances/Total advances	%	11.5	13.8	18.5	28.4
PCR	%	39.8	38.5	38.1	34.3
T1 CAR	%	11.1	9.2	8.1	8.5
H1 Net Profit	Rs. trillion	0.04	0.01	-0.06	-0.04
Additional T1 capital needed*	Rs. trillion	-	0.07	0.22	0.10
At PCR of 70%
T1 CAR (without capital infusion)	%	7.7	4.6	2.1	-0.9
Additional T1 capital needed** (A)	Rs. trillion	0.4	1.0	0.8	0.6
Share of additional capital	%	14	37	29	20
Phase I capital infusion
Allocation (B)	Rs. trillion	0.09	0.35	0.24	0.21
Allocation/Requirement (B/A)	%	24	32	29	40
PCR after Phase 1 allocation	%	43.5	46.7	42.3	45.1
Source: Authors' estimates; Q2 analysts' presentations of PSBs
* To bring T1 CAR to 9.5%, at a existing level of PCR.
** To bring T1 CAR to 9.5%, at a PCR of 70%.

We find that banks in categories 2 and 3 are short of their Tier 1 capital requirement even today. They need around Rs. 0.39 trillion of additional capital in FY 18-19 just to meet the regulatory requirement of 9.5% Tier 1 capital, with no improvement in their PCR. The 12 most stressed banks, those in categories 2b and 3 need close to 80% of this additional capital.

Unless the most stressed banks get additional capital, they will not have the ability to take the haircuts that the IBC outcomes will require them to take. Most stressed corporate loans are through lending consortia which include both the less stressed and the highly stressed PSBs as members. If these weak banks do not receive capital, they will stall the IBC resolution process, thereby affecting the recovery from stressed assets for all banks involved.

Since the most stressed banks are also the ones incurring losses, over time their capital position will worsen. The first phase of capital allocation reflects this reality and allocates the largest share to these banks.

With the Phase I infusion, after meeting the regulatory capital requirements, the overall PCR will increase from the Sept-17 level of 38% to 44.5%. Even at these levels, given that recovery rates are likely to be far lower, PSBs will remain significantly under provisioned.

Could the government have adopted an alternate, more growth oriented allocation strategy?

Not really. Capital for dealing with stress has to precede growth capital.

Table 2 highlights the challenge of allocating the recapitalisation amount among the 21 PSBs. All PSBs are stressed, some less and others more so. Even the relatively less stressed banks like SBI and Indian Bank will require capital infusion to shore up provisions to levels where they can deal with their stressed assets while meeting the regulatory capital requirement. As long as the aggregate supply of capital is less than the Rs. 2.8 trillion that is required (Table 1), there is no allocation scenario under which all PSBs will be able to meet their regulatory capital requirement and also grow their advances.

Within the constraint of the capital committed, we consider some scenarios to evaluate whether any alternate allocation strategies could have prioritised growth.

1. Scenario 1: The entire Rs 0.8 trillion of capital is given to the two banks in category 1 and the less stressed banks in category 2a. The banks in categories 2b and 3 get nothing.

   Theoretically, this scenario can generate some credit growth. The trade-off being that the most stressed banks do not get any additional capital. In reality, this is not a scenario that the government can implement for various reasons:

   • There is a public perception problem. If the government chooses the less stressed banks over the highly stressed ones, it will push the ones that are not chosen into further distress. These stressed PSBs will not be able to raise capital from the market, sell their non-core assets at reasonable valuations, or make recoveries from their stressed assets. It is possible that such an action may cause panic among the investors and depositors of these banks.

   • The highly stressed PSBs, like other PSBs, have raised capital by issuing AT1 or T2 bonds. In most cases these bonds have also been subscribed to by foreign investors. For these banks, a fall in the level of capital below regulatory thresholds will tantamount to a technical default. Since PSBs are owned by the government, their bonds carry the implicit guarantee of the government. A technical default on these bonds would be equivalent to a sovereign default.

   • There is also a question whether some banks can be kept in a state of non-compliance with regulatory capital norms on an ongoing basis. This can only happen if the RBI relaxes its regulatory standards on a selective basis for the most stressed banks. Such an action would be undesirable, from the perspective of systemic risk, and macroeconomic stability.

   • If the highly stressed banks are kept capital starved, they will derail the stressed asset resolution process for other banks in the system as well, as discussed earlier.

2. Scenario 2: The entire Rs. 0.8 trillion of capital is allocated to the 12 highly stressed banks in categories 2b and 3.

   The banks in these categories need Rs. 1.4 trillion of capital infusion (Table 2) to bring T1 CAR to 9.5%, at a PCR of 70%. While their health will somewhat improve with this infusion, the capital gap will continue to exist. Under this scenario, there will be no growth in credit for the next two years. Given that the capital gap will persist, the PSBs may continue to delay recognition and resolution of their stressed assets.

3. Scenario 3: The government merges the highly stressed banks with the less stressed ones, or closes down the highly stressed banks.

   The need for additional capital to deal with stressed assets will not go away with a merger between PSBs. It will continue in the merged entities. Since most PSBs are very similar to each other in the composition of their assets and their liabilities, a linear addition of their balance sheets is not a solution to their stressed assets problem.

   The same holds true even if some of the most stressed banks are closed down. Their assets, including the stressed assets, will need to be transferred or sold to another bank or financial institution at some value. If this sale/transfer takes place at face value, the entities that buy these assets will need the additional capital required to take haircuts and resolve stress. If the sale/transfer takes place at a discount to face value, the banks being closed down will need additional capital to meet all their liabilities and obligations prior to being closed down.

The government does not have a real choice in allocation strategy as long as the capital supplied is less than the capital required for dealing with the PSBs' stressed assets. The requirement for additional capital remains, irrespective of the banking sector strategy that is adopted.

What objectives can recapitalisation fulfill?

The Indian banking system currently faces two big challenges:

1. The banking system is burdened by stressed assets and its existing capital base is inadequate to deal with this problem. Banks need additional capital to take the necessary haircuts to resolve these stressed assets.

2. Bank credit to the industrial sector has stagnated over the last few years. In the last six quarters, quarter-on-quarter bank credit growth has been negative. Non-bank credit sources such as the corporate bond market remain under developed. While there are demand side constraints owing to stressed corporate balance sheets, for an economy growing at 6-6.5%, there are many other segments which are in need of credit. These segments remain credit-starved because of the slowdown in the banking sector. This will have adverse consequences for the overall growth of the economy going forward.

The bank recapitalisation program could be an important step to address both these challenges. It could provide PSBs with the capital required to deal with their stressed assets, and it could revive bank lending, to the extent that demand for credit exists or picks up going forward. However, this can happen if the PSBs hold adequate levels of capital to meet both the objectives.

Our analysis shows that the additional capital that is required for dealing with stress far exceeds what has been committed so far. Only after this capital gap is addressed, can there be a possibility of re-starting credit growth. At the current level of recapitalisation commitment, PSBs will reach a provision cover of 45% on their stressed assets. This implies that they need to recover 50-60% of the value of these stressed assets. This seems highly optimistic given the status of resolution efforts currently underway as part of IBC proceedings.

In the first phase of recapitalisation, the government has decided to inject bulk of the Rs. 0.88 trillion of capital into the most stressed PSBs. Our analysis shows that the government does not have a choice to adopt an alternative allocation strategy that would have revived credit growth. To do that, the overall supply of capital needs to be increased to levels that are in excess of what is required for dealing with the PSBs' stress.

Given that the government has chosen to solve the banking crisis through a recapitalisation program, we have empirically analysed the objectives that such a program may fulfil. The larger issue at hand is the use of taxpayers' money to repeatedly bail out failed banks. Recapitalisation is not the solution to the problems of Indian banking. This needs wide ranging structural and regulatory reforms. The question that needs to be asked is that in absence of such reforms, how wise is it to keep throwing public money at a recurrent problem?

 

Rajeswari Sengupta and Anjali Sharma are researchers at Indira Gandhi Institute of Development Research, Mumbai. The authors thank Joshua Felman and Harsh Vardhan for useful comments and suggestions. We also thank Utso Pal Mustafi of IGIDR for assistance with the data.

Bank recapitalisation: The myth around growth capital

by Rajeswari Sengupta and Anjali Sharma.

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:

1. What is the impact of stressed assets on PSBs'
   capital?

2. How much capital do PSBs need to meet regulatory capital standards?

3. When will PSBs have growth capital?

4. How certain is the recapitalisation package?

5. 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
Asset quality
	Value (Rs. trillion)	As % of gross advances
Gross advances	57.36
GNPA (1)	7.32	12.76
Restructured assets classified standard (2)	1.65	2.87
Total stressed assets (1+2)	8.97	15.64
NNPA (3)	4.15	7.23
Stressed assets requiring provisions (2+3)	5.80	10.11
Capital adequacy
	Value (Rs. trillion)	As % of risk weighted assets
Risk weighted assets (RWA)	58.97
Total capital	7.20	12.22
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.

Table 2a: Provisioning needed at different levels of expected recovery

	Expected recovery rate
	40%	30%	20%
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.

Table 2b: Capital needed at different levels of expected recovery

	Expected recovery rate
	40%	30%	20%
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:

1. Recapitalisation bonds of Rs. 1.35 trillion,

2. Budgetary allocations of Rs 0.18 trillion, under the
   Indradhanush Scheme, and

3. 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.

Conclusion

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.

NPA Ordinance: The impact of secrecy in ordinance making

by Pratik Datta and Rajeswari Sengupta.

In a liberal democracy law making should be a transparent affair. Transparency allows constructive public debate before a law is imposed on the society. In USA, the secrecy surrounding the drafting of the Senate Health Care bill meant to repeal Obamacare has been widely criticised. In contrast, we in India are so used to secrecy in legislative drafting that we do not even question it. We are content that bills introduced in the Lok Sabha and Rajya Sabha are at least publicly available.

Even this minimal transparency is denied to Indian citizens when the same bill is sent by the Cabinet to the President for 'promulgation' as an ordinance. The draft of the ordinance is not released in public domain till the President signs it and brings it into force. Unlike Parliamentary laws, there is no opportunity for public debate and discussion around a draft ordinance that has been approved by the Cabinet till it is imposed on the society. We saw this happen with the recent Banking Regulation (Amendment) Ordinance, 2017:

• There had been speculation in the media since March 2017 that the Government was planning to take steps to resolve the stressed assets problem in the banking sector.
  
  
  
  Figure 1: Google searches on 'NPA Resolution'
  The graph above plots data from Google Trends. It shows the interest over time in the words 'NPA Resolution'. The graph plots the number of web searches done between the weeks starting March 5, 2017 and May 14, 2017. From March 19 onward, there was a sharp increase in the number of searches that used the words 'NPA Resolution'. The interest subsided in the week starting April 23 and picked up significantly in the week starting April 30, the same week when the NPA ordinance was first announced and then publicly released. From March 2017 onward, there were also news in the media that the Government was planning to empower the Reserve Bank of India to deal with stressed asset problem (see here and here).
• On May 3, 2017 the Cabinet approved the Banking Regulation (Amendment) Ordinance, 2017. The media carried reports about the Cabinet approval but the text of the draft ordinance was not publicly available (see here and here). Around 7:49 pm on May 3, 2017, the Finance Minister mentioned in a media briefing that the Cabinet's recommendation has been sent to the President. He did not disclose any further detail on the ground that: There is a convention that when some proposal is referred to the President, then details of it cannot be disclosed till it is approved (sic).
• On May 4, 2017 the President signed the Ordinance. The text of the signed ordinance was still not publicly available.
• On May 5, 2017 the ordinance was released in public domain when it was uploaded onto the e-gazette at 12:38 PM.

In other words, even after the Cabinet approval on May 3, the text of the ordinance was withheld from the public till May 5. What was the impact of this secrecy convention? In this post we answer this question by examining the movement of the Nifty, the Bank Nifty and the PSU Bank Nifty indices before and after the public release of the ordinance.

Impact of the secrecy convention

Once the Cabinet provisionally agrees that an ordinance is needed, a bill is drafted. The draft bill is then sent to the President for promulgation as ordinance. As per the unwritten convention cited by the Finance Minister, the text of the ordinance is kept secret from the public till it gets uploaded on the egazette website. However, as seen during the promulgation of the Banking Regulation (Amendment) Ordinance, although the text was kept secret, selected information about the ordinance was released by the government to the media. There
was much speculation in the media about the details of the proposed ordinance.

Figure 2: Prices

The graphs above plot the three stock indices for the trading days around May 5. They run from the start of the trading day on May 2 to the close of trading on May 8. Trading was closed on the weekend of May 6 and May 7. The first two graphs from the top show the cumulated market model residuals of the Bank Nifty index and the PSU Bank Nifty index, respectively. The bottom-most graph shows the movement in the Nifty index around the event. The event identified in the graphs is the public release of the NPA ordinance at 12:38pm on May 5.

After the Finance Minister's press briefing on the evening of May 3, Nifty traded higher on May 4 than on the previous two trading days. Right after the ordinance was made public at 12:38pm on May 5, it fell till about 1:40pm before correcting marginally and ended the day lower than the previous two trading days.

A similar price movement is seen in the Bank Nifty index. The movement is much more pronounced in the PSU Bank Nifty index. Both the Bank Nifty and the PSU Bank Nifty indices went up between May 3 and May 5 (before 12:38 pm), the time period during which the secrecy convention was supposedly being followed. This suggests that the Finance Minister's media briefing on the evening of May 3 and the selective release of information was treated as positive news by the market. However the upward price movement came to a halt when the full text of the NPA ordinance was made public at 12:38pm on May 5 following which the prices fell sharply. The decline was more pronounced for the PSU banks.

It is worth noting that the prices had actually started falling a little before 12:38pm on May 5, particularly for the PSU banks. So it is possible that news of the text of the ordinance got leaked to the market even before the official release of the ordinance.

Figure 3: Volatility

The graphs above show the volatility in the returns of the three indices around the release of the NPA ordinance. There was an increase in the volatility of both the Bank Nifty and the PSU Bank Nifty indices after the ordinance was made public on May 5. The volatility increase was much more prominent for the PSU banks.

Market's negative reaction

The negative reaction of the market following the public release of the ordinance reflects the mismatch between market expectations and the final text of the ordinance. Between May 3 and May 5 (before 12:38 pm), market expectations were fuelled in the absence of the full text of the proposed ordinance. The selective release of information by the government triggered expectations in the market that the proposed ordinance would offer a comprehensive solution to the stressed asset problem of the banking sector. However, once the text of the ordinance was made publicly available at 12:38 pm on May 5, it was not evident to the market how the ordinance would be able to tackle the NPA crisis. The ordinance gave rise to more questions than it answered (see here). Consequently, the market reacted negatively.

Conclusion

Secrecy has been an inherent trait in ordinance-making since the times of the British Raj. Post-independence, while giving ordinance making powers to the President, the Constitution framers did extensively deliberate on the potential misuses of such powers. But they never questioned the secrecy around ordinance making. Consequently, Article 123 of the Constitution empowers the President to promulgate ordinances but does not explicitly require transparency in the ordinance-making process. It is then hardly suprising that even the Supreme Court has over time accepted that open legislative debates and discussions do not apply to ordinances.

It is high time we question this secrecy. As we have seen above, the secrecy convention coupled with the discretionary release of partial information about the recent Banking Regulation (Amendment) Ordinance, 2017 led to information asymmetry in the stock market, causing market inefficiencies. To avoid such inefficiencies, the government should make the ordinance-making process transparent by discarding the age-old secrecy convention and officially releasing the proposed ordinance immediately after it is approved by the Cabinet. Complete transparency in ordinance-making will also be in sync with the broader philosophy of legislation-making in a modern liberal democracy.

 

Pratik Datta is a researcher at the National Institute of Public Finance and Policy, New Delhi and Rajeswari Sengupta is a researcher at the Indira Gandhi Institute of Development Research

Bureaucrats in business: The tension between rule of law and commercial considerations

by Anirudh Burman, Shubho Roy, Ajay Shah.

How to achieve high performance in government

In government, the route to performance lies in clarity of objectives and accountability mechanisms, grounded in the rule of law. Every transaction undertaken by a government must be grounded in a written down process, must treat all legal persons equally (Article 14 of the Constitution), must go through due process, must be open to questioning later on. All persons must have full documentation about how the government will behave under various circumstances, must be given documentation about how their transaction was processed, and explained why. Coercive actions of the State must be subject to judicial review. Purchases must be made through General Financial Rules (GFR).

How to achieve high performance in business

These bureaucratic processes have no place in the world of business.

For a firm, counterparties have no Article 14 rights. A manager must choose to give a contract to vendor A or vendor B based on an overall sense of how this will work out. The manager is not obliged to give a reasoned order or even to treat vendors equally.

In finance, private persons choose to buy equity or debt by exercising their own judgment. There is no obligation to have due process or to face audits that question commercial decisions.

This gun-slinging exercise of discretion works because the competitive market sorts it all out. Firms are kept on their toes by the accountability mechanism of the market. Firms get high speed feedback from the market about how they are faring. Good decisions yield improved profits and improved stock prices, and vice versa.

Phase I of India's journey

When Indian socialism was being constructed, the government wanted to be in business. There is a fundamental contradiction between the decision processes that are required in business when compared with the rule of law.

The solution adopted was to sacrifice the rule of law. All across the Indian state, we got politicians and bureaucrats wielding arbitrary power. The construction of Indian socialism damaged India's institutional capital.

Phase II of India's journey

In recent years, the tide has turned decisively. The Constitution of India is asserting itself. We are building the rule of law, we are restoring the institutional capital. You can no longer fudge the process for allocation of spectrum or coal mines. The old clubby ways are being stripped away, all across government.

Some people continue to yearn for the bad old days when a bureaucrat wielded unchecked power, but those days are safely behind us. As an example, see: CAG asks why Air India sold five Boeing 777s at loss to Etihad in 2013 by Mihir Mishra in today's Economic Times.

This great push towards the rule of law has one important implication: the push for the rule of law makes it  harder for the government to do business.

In the olden days, a public sector company could exercise discretion, and participate in the world of business, because the rule of law in India was in tatters. Now that India is pushing back into rebuilding the rule of law, this makes life difficult for the parts of government that are engaged in commercial activities.

On an international scale, we generally see that in countries with strong rule of law, we don't see public sector companies. The intuition that has been offered, in the past, is that there is a deeper thing called `good institutions'; in countries with good institutions, we see the rule of law and we see the absence of public sector companies. Conversely, when there is low institutional quality, we see failures on the rule of law and we see the phenomenon of public sector companies.

The main argument of this article is that there is another causal connection in the picture. A country that sets out to have public sector companies will damage the rule of law, and a country that sets out to strengthen the rule of law will damage public sector companies. Perhaps countries with strong rule of law lack public sector companies as those rule of law strictures have interfered with their functioning.

Implications for public sector companies e.g. public sector banks

In the best of times, it is difficult for bureaucrats to be in business. All over the world, there is ample evidence that government ownership of business hampers productivity. Layered on top of this is this new twist. Earlier, a bank in India could exercise more arbitrary power in trading securities, giving loans, restructuring bad loans, etc. But once public sector banks come under the full strictures of the rule of law, this becomes harder. India's drive towards the rule of law is detrimental to the concept of a public sector company that is owned by the government but engages in commercial activities.

We repeatedly hear public sector bankers complain that it's impossible to do the business of banking when placed under the myriad accountability mechanisms of the government. Their solution is that the rule of law is optional, that banks should be exempted from these requirements even when banks are owned by the government. We suggest that the solution lies in government getting out of banking.

Where is the line drawn, where a public sector company is the State?

Article 12 of the Constitution says: In this part, unless the context otherwise requires, the State includes the Government and Parliament of India and the Government and the Legislature of each of
the States and all local or other authorities within the territory of India or under the control of the Government of India.

This is important because Part III (fundamental rights) can be claimed against the State, such as equal treatment, non-discrimination, etc.

Here the word `includes' implies that this is not an exhaustive definition. The courts have developed tests to determine what `other authorities' means. The key case is Ajay Hasia. These questions turn on the issues of control and financing: (a) the degree of government control over the administration of the authority, (b) the degree of funding/ grants made to the authority, (c) power to appoint/ remove officials, etc. Based on these criteria, various kinds of entities such as public sector companies, educational institutions that receive government money, etc., have been termed state.

When the government owns less than 50% of a commercial enterprise, that organisation is generally not classified as State. However, evidence of pervasive control in such cases may lead to a judicial
determination that the entity is "state" under Article 12. For statutory monopolies or organisations with pervasive State control, even going below 50% ownership does not elude classification as State. In the case of R.D.Shetty v. International Airport Authority of India the Supreme Court stated that an entity such as the International Airports Authority could not act arbitrarily, but was subject to constitutional requirements.

It stated that, ...power or discretion of the government in the matter of grant or largesse including award of jobs, contracts, quotas, licences etc. must be confined and structured by rational, relevant and non-discriminatory standard or norm.... It then went on to say that corporations established by statute, or incorporated under law (including any company under the Companies Act) are "state"
if they satisfy certain tests based on:

1. The source of share capital.
2. Extent of state control over the corporation, and whether it is deep and pervasive.
3. Whether the corporation has monopoly status.
4. Whether the functions of the corporation are of public importance and closely related to governmental functions; and
5. Whether, what belonged to a government department formerly was transferred to the corporation.

For a more detailed answer, see this report of the Law Commission (page 4, paras 2.3 to 2.6).

Three important issues arise related to the 1979 ruling of the Supreme Court:

1. A business entity making a commercial decision does not hand out contracts as a "grant or largesse", but as a competitive player in the market interested in purchasing goods or services that satisfy its own requirements. To constrain it by the rule of law is to fetter its commercial decision making process.
2. The transition of the Indian state is different from the transition of many western democracies such as the USA and UK. These democracies transitioned from laissez faire states to
   regulatory states. The Indian state on the other hand, is transitioning from a pervasive state to a regulatory state. Until not too long ago, the state ran hotels and manufactured bread. As such, most functions sought to be deregulated and/or performed by companies/ corporations are or were of public importance, and closely related to governmental functions.
3. In India, many government functions are being privatised or handed over to government companies. A good example is telecom. Telecommunication services were first transferred to public sector companies owned by the central government, and eventually privatised.

On a related note, GFR has a rule to prevent escaping from GFR through subsidiarisation: Once government provides majority funding to a body, it must accept GFR and CAG.

This results in a situation where though de jure transfers of control, ownership and management have taken place, for government owned/ controlled corporations, there is never a complete de facto escape from the constitutional constraints on the Indian state. Such entities are unable, from the point of inception to act purely on commercial motives. It is therefore questionable whether any government
strategy that aims at greater market discipline and efficiency in a sector can be successful through the route of establishing government owned/ managed entities. Alternatively, the precedent on what constitutes "state" needs to be reviewed. The judgements on what constitutes "state" were made in the era of a pervasive state. A regulatory state must be defined differently.

Important work by cobrapost that illuminates high-powered incentives

The investigative journalism by cobrapost, their videos, and Monika Halan in Mint add up to an important story.

Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.

Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.

In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.

Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.

A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don't, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.

For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it's easy for us to overdo this message. In many situations, I feel it's better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.

These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay. 

This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.

One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.

A prominent example of this debate has been `financial market infrastructure institutions' (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.

Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.

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.

Should government capitalise public sector banks?

by Harsh Vardhan.

What would you say if someone was borrowing money at 8% and investing it to earn around 3%? "Uninformed!", "financially illiterate!" or even outright "foolish"! And yet this is what our government has been doing with trillions of rupees over the last many years and has committed to continue to do so in the future. The process by which this is done is called capitalisation of public sector (PS) banks. Such capitalization is not only a bad idea economically as it puts enormous stress on the government resources, but also one which affects that behavior of banks and hence the robustness of the whole banking sector.

Commercial banks need capital to grow. Capital adequacy requirements ask all banks to keep a minimum amount of shareholder capital in proportion to their balance sheet size. Currently, in India this requirement is 9% of "risk weighted assets" of banks. Roughly, it means that banks are expected to have equity capital which is 9% of their commercial loans.

As banks grow their business, their risk weighted assets also grow. This means that banks has to increase their capital base in line with the growth of their loan book. Such increase in capital can come from exactly two sources - retained profits that are added to the capital base, or fresh infusion of capital from shareholders (old or new). In India, given the overall profitability of the banks (~1.1% return on assets) and the amount of dividend that they pay (~20%) of post-tax profits, banks do not have enough retained profits to support their business growth. Therefore, every now and then, they go to shareholders to raise fresh capital.

PS banks pose a peculiar challenge for the government. Being the majority owner of these banks and having committed to stay the majority owner, government has to infuse capital into these banks proportional to its ownership stake. Since the government wants to maintain its ownership at 51%, it has to supply atleast 51% of the fresh capital that PS banks need. RBI governor Dr. Subbarao, in a recent speech, said that the capital infusion by government into PS banks over the next decade will be of the order of Rs.0.9 trillion. I have read estimates of other analysts where this number is as high as Rs.2.50 trillion. These estimates depend on the assumptions one makes about a number of factors - the rate of growth of banks (which in turn depends on the growth of the overall economy), the profitability of banks, their dividend policy, their ability to raise other forms of capital (especially tier II capital), regulatory requirements on capital, etc. No matter how you estimate it, the number is very large. In other words, the government will be compelled to invest a very large amount of capital into PS banks over coming years.

Why is this a problem? Let’s look at the some simple public finance issues. India is in a deep fiscal crisis, and it is not easy to find trillions of rupees to put into PS banks. If such resources were injected into PS banks, it is not conducive to healthy public finance, since these injections are not a good deal for the government. The Indian government currently borrows long term money at over 8%. The dividend yield on PS banks shares has been between 2% and 3% over the last decade. This means that the government earns between 2% and 3% on its investments in PS banks. There is a 5% “negative carry” or loss that government bears on these investments.

A private investor also earns a low dividend yield from investing in PS banks, but can benefit from capital gains - a potential increase in the value of shares which the investor can obtain when she sells the shares. Government has never sold shares of PS banks (except when it initially listed some banks) and will not do so if it has to maintain majority ownership which is its stated policy. Hence, for the government, the financial analysis of a proposal to put money into PS banks should hinge on a comparison between the flow of dividends versus the cost of borrowing.

Capitalisation of PS banks is, thus, bad for government finances. It's a double whammy! On the one had government has to raise vast resources to be invested into banks and then carries a loss of around ~5% on these investments year after year.

Ownership and behavior of banks

Government capitalisation of PS banks is not just a fiscal challenge. It also impacts the competitive dynamics of the banking industry. Most privately owned banks are under constant scrutiny of investors and analysts. When they go to external investors for raising capital, they have to satisfy these investors on number of critical aspects of the business - profitability and its sustainability, efficiency of capital use, quality of management team, cost efficiency, etc. In other words, private banks face a market test; they do not get capital for free. Only well run private banks get equity capital that is required for growth.

None of these questions get asked when government puts capital into a PS bank. One has never heard a senior government official commenting on the Return on Asset (RoA) or Return on Equity( RoE) of PS banks. The decision to put capital into PS banks is treated as a mechanical and administrative decision. This absence of a market test has systemic consequences. PS banks have ~70% share of the Indian market. When the majority owner is asking no or very few questions on performance, and is assuring an almost unlimited supply of capital, these banks have little incentive to improve financial metrics such RoA and RoE. This hurts the overall banking industry. For example, PS banks can underprice loans compared to their private sector peers. Such behavior would migrate the whole business to lower returns. It is hard for a private bank to be profitable when facing rivals that are not concerned about return on capital.

Misplaced obsession with majority ownership

The source of this whole capitalisation issue is the government's obsession with retaining majority (over 51%) ownership of PS banks. This is often explained in terms of the need to maintain the "public sector character" of these banks. While there may be a separate debate on whether we need to maintain public sector character for all the 25 plus PS banks, the fact is that the government does not need majority ownership to achieve this objective.

  All PS banks are not companies under the Companies Act. The notion of 51% giving majority control is enshrined in the Companies Act. PS banks were created under the Nationalisation Act (SBI has its own SBI Act). The Nationalisation Act provides the government untrammelled control over these bank. While it does prescribe 51% government ownership in the PS banks, the control of government is independent of the level of its ownership. Furthermore, there is a limit of a 5% (10% with prior approval of the RBI) stake owned by any single shareholder in all banks. There is no chance, therefore, of any external shareholder acquiring control in these banks. Even relatively minor changes to the functioning of PS banks require approval of the parliament. Where is then the question of diluting the public sector character if the government ownership were to drop to, let's say 26%, which is the threshold for "significant" minority stake in a company?

In the long run, therefore, it makes no sense for the government to commit itself to the capitalisation of PS banks. Precious government resources can be better deployed in critical areas (such as power transmission and distribution) where private capital on large scale is hard to come by. In the medium term, it can use tactical measures such as merging banks where it has significantly high ownership with those where the ownership is already down to 51%. But these tactics will not solve the issue structurally. The only long term solution is to give up the majority obsession, explain to all the stakeholders the fallacy of this obsession and the resulting pressure on public finance, build a political consensus to enact necessary legislative changes and then dilute down to a reasonable level.

Should government put fresh equity capital into State Bank of India?

The discussion about State Bank of India (SBI) has treated one proposition as a given: that it is the job of the Ministry of Finance to continually inject capital into SBI so as to enable the growth of the SBI balance sheet; that SBI has a legitimate claim upon fiscal resources at all times.

I'm not sure this is a good way to think about the business of banking. The first task of a bank should be to produce adequate retained earnings so as to support the desired growth. If a bank cannot produce retained earnings enough to grow, there is reason for thinking that it should not grow.

Let's compare the performance of the best private bank (HDFC Bank) and a good PSU bank (Bank of Baroda) from this perspective.

Growth of the balance sheet and leverage

Let's look at how the two banks have fared, from 1999-2000 onwards, on the core issues of balance sheet growth and leverage:

	1999-2000	2010-11
Bank of Baroda
Total assets	58,623	358,397
Leverage	18.12	17.07
HDFC Bank
Total assets	11,731	277,429
Leverage	15.33	10.93

From 1999-2000 to 2010-11, there has been a sharply superior performance by HDFC Bank. At the start, it was a small bank - with a balance sheet of just Rs.11,731 crore while BOB was roughly 5x bigger. By the end, HDFC Bank was at a balance sheet size of Rs.277,429 crore while BOB was at Rs.358,397 crore.

What is more, HDFC Bank did this while being more prudent: they deleveraged in this period: They went from a leverage ratio of 15.33 to a leverage ratio of 10.93. In contrast, BOB stayed at a much higher leverage (18.12 at the start and 17.07 at the end).

The bottom line: BOB grew net worth by 6.5 times and the balance sheet by 6.11 times. HDFC Bank grew net worth by 33.17 times and the balance sheet by 23.65 times.

So how did the net worth grow?

In the naive intuition that's being bandied about in the discussion about SBI, there would be an expectation that the expansion of net worth would be obtained by asking shareholders (new or existing) for money. What happened in HDFC Bank and BOB was a bit different.

The hallmark of a healthy bank is the production of retained earnings which can be ploughed back into the business. HDFC Bank did that: over this period, it brought 13.23% of total assets (summing across the 12 years) back into the business, so as to grow net worth. BOB did not do as well: it brought only 7.86% of total assets back into the business.

In addition, HDFC Bank raised 13.66% of total assets by bringing in fresh capital. BOB, in contrast, brought in only 2.11% of total assets into the business. You could criticise the Ministry of Finance for being niggardly in giving BOB equity capital.

Summary

A well run bank must put retained earnings back to work. If a bank is unable to fund its own growth by increasing net worth through retained earnings, there is reason to be concerned about the health of the core business.

A steady flow of new capital from shareholders, in order to enable growth, is not that different from recapitalisation in response to bad assets.

Public money is precious. The Ministry of Finance would do well to be very, very stingy in doling out public money to PSUs. Each Rs.5000 crore that goes into a PSU comes at an opportunity cost of 1000 kilometres of NHAI highways which could have been built using that money.

If a PSU cannot grow its balance sheet, odds are the problem lies within: it needs to become a better run business and thus grow the balance sheet using retained earnings. Such PSUs are precisely the ones who are the least deserving to gain fresh capital. If anything, fresh capital should be directed into banks like HDFC Bank (as the private capital markets have), who are doing a great job of producing retained earnings.

The two great industries of Bombay

A few years ago, when Percy Mistry's committee was working on the MIFC report, I used to joke that of the two great industries in Bombay, movies will make it first to international customers. A few days ago in the New York Times, Anupama Chopra has a story showing that some action on that front is now visible.

Winning on a global scale in finance and in movies has some common features : it involves raw materials like human capital, top end computer technology, freedom of speech, openness to other cultures, a large home market, the natural opportunities of connecting up with the disapora, and Schumpeterian creative destruction.

With all these in place, Bombay's movie industry is nicely globalising itself. Finance requires all these - and that bodes well for BIFC. But finance requires a few more things. It requires sophisticated financial regulation, and a sound macroeconomic policy framework. It requires that the government get out of producing financial services just as the government does not produce movies. India has a tonne of work to do on these.

Interesting features of the budget speech

Financial stability, regulatory coordination, financial reforms

So far, in India, regulatory coordination was based on the HLCC. This has not been a particularly good experience. The HLCC was not statutory and there was no defined mechanism through which decisions would be obtained. Many inter-regulatory difficulties simply languished. One peculiar aspect of the HLCC was that it was chaired by the RBI governor, while RBI was at the centre of many inter-regulatory disputes. It was awkward, having one of the competing views on a question being the chair.

On these questions, the Raghuram Rajan report had said:

A Financial Sector Oversight Agency (FSOA) should be set up by statute. The FSOA's focus will be both macro-prudential as well as supervisory; the FSOA will develop periodic assessments of macroeconomic risks, risk concentrations, as well as risk exposures in the economy; it will monitor the functioning of large, systemically important, financial conglomerates; anticipating potential risks, it will initiate balanced supervisory action by the concerned regulators to address those risks; it will address and defuse inter-regulatory conflicts, and look out for the build-up of systemic risks. 

The FSOA should be comprised of chiefs of the regulatory bodies (with a chair, typically the senior-most regulator, appointed from amongst them by the government), and should also include the Finance Secretary as a permanent invitee. The FSOA should have a permanent secretariat comprised of staff including those on deputation from the various regulators. There should be a prescribed minimum frequency of meetings of the FSOA. All issues of regulatory co-ordination, and supervision of systemically important financial conglomerates and financial institutions will be taken up by the FSOA. 

The discussions of the FSOA with the management of systemically important institutions will be principles-based, and ts will initiatete the process of gradually implementing more principles-based regulation throughout the system. It will be important that the FSOA add value by substituting for some existing processes instead of adding another layer, while bringing collective regulatory views to bear. It is not our intent that the FSOA be a super-regulator displacing existing regulators. Instead it provides needed coordination and fills gaps that current structures have proved inadequate for. 

In addition, there is merit in setting up a Working Group on Financial Sector Reforms with the Finance Minister as the Chairman. The main focus of this working group would be to monitor progress on financial sector reforms (such as the proposals of the Patil, Parekh, Mistry, and this committee), and to initiate needed action. The working group's membership would include the regulators, as well as ministries on as-needed basis. The working group would be supported by a secretariat inside the Finance Ministry.

There was a contrasting view. After the global financial crisis, we got a strong campaign by RBI, based on the proposition of financial stability. It was claimed that now that financial stability is important, the original role and structure of RBI (as envisaged in the 1934 legislation) is the right one, so all reform proposals should now be shelved. Suggestions were made that the financial stability function should be handed over to RBI, which could ultimately lead to RBI becoming the super-regulator of finance, with the power to give instructions to other regulators such as SEBI based on financial stability considerations. Every bureaucracy likes to stave off change, and to grow its turf, so the arguments put forward by RBI were less than persuasive given its self-interest.

I have been skeptical about the idea of placing financial stability functions at RBI, for a few reasons:

• Crisis management involves utilisation of taxpayer resources, which can only be authorised by the treasury. Indeed, if a banking regulator is given a stability function, he will be inclined to cover up for the failures of banking supervision by utilisation of taxpayer money.
  There is a similar problem when a banking regulator who is also a central bank is inclined to cover up for the failures of banking supervision by giving `short-term liquidity support'. This problem is already with us in India. We should not make matters worse.
• The essence of financial stability thinking is to break out of India's silo system, and look at the overall financial system. The inhabitants of any one silo in India are likely to be ill equipped to think about the overall financial system.
• Financial stability thinking repeatedly involves asking any one regulatory agency to question its existing way of thinking. If an existing agency doing a lot of financial regulation is asked to do financial stability, this will not come about. Worse, there is the danger of `regulatory capture' where every regulatory agency tends to adopt the world view and maximisation of its firms. If RBI is asked to do financial stability work, we run the risk that these new levers of power will be used to favour banks at the expense of other kinds of financial firms.
• It is hard to obtain sensible notions of transparency and accountability in the nascent field of financial stability. There is much merit in a principal-agent problem approach in designing the block diagrams of government. When a clear document can be written down specifying a job that has to be done, then it is better for government to contract that out to an external agency, since the clarity of mandate makes possible accountability. But for the things where a clear contract cannot be written down, contracting-out to an external agency is hard, and it is better to in-source these functions.
• New work that we initiate in India should not interfere with our long term goals of establishing a proper central bank.

I am quite comfortable with the two interesting models out there. In the US, there are many financial regulators, and stability functions are being placed in a council of regulators. That makes sense. And in the UK, the Bank of England does no financial regulation, and it has been asked to do stability work. That also makes sense since the BoE takes an outsiders view of the work of the FSA. The staff quality of the Bank of England also encourages confidence that this will be in a technically sound way, without being imbued with an ideology of hostility to finance. In an Indian setting, both approaches make sense. One path would involve removing all financial regulation from RBI, turning it into a high quality central bank setup with staff quality matching that of the BoE, and then tasking it with the financial stability function. The other path is to place financial stability with a council of regulators.

This debate had simmered for some time. In the budget speech today, the Finance Minister announced the decision taken by government on how this should be handled:

37. The financial crisis of 2008-09 has fundamentally changed the structure of banking and financial markets the world over. With a view to strengthen and institutionalise the mechanism for maintaining financial stability, Government has decided to setup an apex-level Financial Stability and Development Council. Without prejudice to the autonomy of regulators, this Council would monitor macro prudential supervision of the economy, including the functioning of large financial conglomerates, and address inter-regulatory coordination issues. It will also focus on financial literacy and financial inclusion.

This seems to be some kind of fusion between the Raghuram Rajan proposals of the FSOA and the Working Group on Financial Sector Reforms. More details are awaited from DEA on how they want to play this.

Financial Sector Legislative Reforms Commission

The four major committee reports on Indian finance -- Patil, Mistry, Rajan and Aziz -- have all emphasised a comprehensive overhaul of outdated laws. The laws of 1934, 1952, 1956, etc. are quite out of touch with the India of today. And this job is complicated by the fact that one amendment to the laws at a time does not cut it. You might like to see my article in Pragati magazine in August 2009, where I argue that changing the laws is the essence of financial reform in India today.
In today's budget speech, the FM said:

101. Most of our legislations governing the financial sector are very old. Large number of amendments to these Acts made at different points of time has also increased ambiguity and complexity. The Government proposes to set up a Financial Sector Legislative Reforms Commission to rewrite and clean up the financial sector laws to bring them in line with the requirements of the sector.

Large complex IT-intensive projects

Stepping away from new laws, economic reform in India is critically about big and complex IT systems. These present unique challenges of public administration, when compared with the traditional ways of working of government in India. A new process manual is required through which these big complex IT-intensive projects can be rolled out and run.

In today's budget speech, the FM said:

104. An effective tax administration and financial governance system calls for creation of IT projects which are reliable, secure and efficient. IT projects like Tax Information Network, New Pension Scheme, National Treasury Management Agency, Expenditure Information Network, Goods and Service Tax, are in different stages of roll out. To look into various technological and systemic issues, I propose to set up a Technology Advisory Group for Unique Projects under the Chairmanship of Shri Nandan Nilekani.

Co-contribution for unorganised sector in NPS

There is an increasing sense that a government should help grow the participation of the informal sector in a defined-contribution individual account pension system by having co-contribution. In today's budget speech, the FM said:

90. To encourage the people from the unorganised sector to voluntarily save for their retirement and to lower the cost of operations of the New Pension Scheme (NPS) for such subscribers, Government will contribute Rs.1,000 per year to each NPS account opened in the year 2010-11. This initiative, "Swavalamban" will be available for persons who join NPS, with a minimum contribution of Rs.1,000 and a maximum contribution of Rs.12,000 per annum during the financial year 2010-11. The scheme will be available for another three years. Accordingly, I am making an allocation of Rs.100 crore for the year 2010-11. It will benefit about 10 lakh NPS subscribers of the unorganised sector. The scheme will be managed by the interim Pension Fund Regulatory and Development Authority. 

91. I also appeal to the State Governments to contribute a similar amount to the scheme and participate in providing social security to the vulnerable sections of the society.

A coherent vision for pension reforms is not yet in place: right alongside this, the government talks about a National Social Security Fund for unorganised sector workers with Rs.1000 crore.

Entry barriers in banking

One of the key mistakes in Indian banking has been the entry barriers: until recently, the rules inhibited placement of ATMs, placement of branches, new private banks, branches by foreign banks, money market mutual funds. There has been some progress on placement of ATMs and branches in recent months. A next step was announced in the budget speech:

38. The Indian banking system has emerged unscathed from the crisis. We need to ensure that the banking system grows in size and sophistication to meet the needs of a modern economy. Besides, there is a need to extend the geographic coverage of banks and improve access to banking services. In this context, I am happy to inform the Honourable Members that the RBI is considering giving some additional banking licenses to private sector players. Non Banking Financial Companies could also be considered, if they meet the RBI's eligibility criteria.

A coherent vision for banking policy is not yet in place: right alongside this, the government promises to put Rs.16,500 crore or roughly 0.3% of GDP to increase the equity capital of PSU banks.