Cutting govt stake in banks to 52% is half reform; full privatisation is the need

The Narendra Modi government is clearly in no mood to push the idea of privatisation of India’s public sector banks, which control 70 percent of the total assets of the country’s Rs 89 lakh crore banking sector and at least three-fourth of their combined branch network.

In the first seven months of Modi, the very idea of privatising state-run banks has not found place in a meaningful way even once.

Probably, the government’s strategy is to maintain the control of state-control of banks and try improving their performance by making changes in the structure within.

While the reason behind Modi’s aversion to privatisation isn’t clear yet, his colleague finance minister Arun Jaitley seems to have plans ready to meet the funding needs of sarkari banks by partly lowering the government’s holding in them.

To kick off the process, the cabinet on Wednesday approved a plan to raise about Rs 1.6 lakh crore ($25.76 billion) by selling some of its stakes in state-run banks by 2019, by bringing down the holding to a minimum 52 percent.

At present, the government holds stakes ranging from 56 percent to 84 percent in 27 state-run banks. Government wants state-run banks to go to the market and raise capital tapping the retail investor base, keeping the minimum government holding at 52 percent. But this process will give only a temporary breather to state-run banks given their massive capital requirements.

Let’s take a look at the capital requirement of these banks. According to the P J Nayak committee, which looked at various aspects of public sector banks, state-run banks would need over Rs 3 lakh crore capital if their loan book grows 16 percent per year and if about one-third of their restructured loan portfolio turns bad.

On the other hand, advanced capital requirements under the Basel-III norms, are fast approaching. To conform to this, sate-run banks will need to raise substantial amount of capital.

According to global ratings agency Moody’s Investors Service, the amount state-run banks need by 2019 is estimated between Rs 1.5 lakh crore and Rs 2.2 lakh crore, or $26-$37 billion, to comply with the so-called Basel-III norms.

This estimate covers just 11 state-run banks that the agency rates. These are estimates and the actual requirement could vary, likely on the upside.

Basel-III is the advanced capital norms all banks worldwide need to comply with in a phased manner. For Indian banks, the deadline is 2019.

As per the Basel-III norms, banks need to have minimum equity capital adequacy ratio of 7 percent and Common Equity Tier-1 (CET-1) capital of 5.5 percent. A Firstbiz analysis of Capitaline data shows that at least five government banks have Tier-I capital adequacy less than 8 percent.

In addition, banks will also need to build a 2.5 percent capital conservation buffer to be used in bad times. Basel-III requirement is only one side of the story.

On the other hand, the stressed asset scenario could emerge as the major risk for state-run banks. At present, the stated amount of bad loans in the banking system is Rs 2.7 lakh crore, while the restructured loans are estimated to be between Rs 5 lakh crore and Rs 6 lakh crore.

The real risk is that not all bad loans are correctly reflected on the books of state-run banks. Many are hidden in the form of restructured advances. Admitting bad loans to restructured pile and thus keeping them standard, is a temporary rescue operation done by banks based on the idea of mutual convenience.

For the borrower, this helps to avoid the tag of a defaulter and banks can show lesser bad loans on the balance sheet. It is difficult to estimate how much of the actual bad loans are hidden this way, but banks’ reluctance to acknowledge the base problem paves way to a risky future of unknown risk and the resultant capital requirements.

Also, while, the loan demand is currently yet to pick up and still struggling to attain double digit growth for most banks, once the economy is back on track of higher growth, the demand scenario will change, necessitating banks to keep sufficient money ready to meet the loan demand.

In short, the currently estimated capital requirements for public sector banks can change drastically and the government might not be in a position to continuously feed these lenders given the fiscal constraints.

The permanent solution for the ‘capital’ problem of sarkari banks, as the P J Nayak committee suggested, is to privatise these banks by bringing down government stake below 51 percent and letting these entities operate as private entities.

The government can ensure that shareholding of these banks is distributed widespread among the retail investors so that no single private investor can call the shots in their operations.

Besides offering them immediate leeway to raise funds, such a step will also help the new set of private banks to become more competent institutions without intervention from the government bureaucracy and politicians in their business and enabling them bargain better in the market to raise capital.

To be sure, the weaker banks among them may not be able to survive. They will likely get merged with bigger ones, which should be the case in a free market. Only the fittest should survive.

Clearly, the government’s capital infusion in state-run banks, is proving to be much lesser than what is actually needed by them. In the past four years, the government has infused just about Rs 60,000 crore and in the current year, the budgeted capital infusion is Rs 11,200 crore.

The government could begin the process of privatizing in three or four mid-sized and smaller banks and act later on bigger ones based on the initial experience. At present, the government holds more than 70 percent stake in 12 state-run banks and over 80 percent in six. As Firstbiz has noted earlier, the government shouldn’t be in the double role of an owner and market player at the same time by running banks.

Lowering government stake in state-run banks to 52 percent will give only a temporary solution. It is time the Modi-government give a serious thought about privatizing public banks, especially given the equity markets are on a bullish course.