What Moody's warning really means: Govt needs to privatise public banks, now

Questions about the ability of the Modi-government to meet the capital requirements of India’s public sector banks (PSBs) continue to increase in number. On Monday, global ratings agency Moody’s Investors Service estimated the amount state-run banks need by 2019 between Rs1.5 lakh crore to 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. The actual requirement of capital that all public sector banks need would be even higher.

Moody’s has flagged the fact that India’s state-run banks barely manage to meet the minimum capital requirements. The agency anticipates the government, which is struggling to reduce its budget deficit, will find it difficult to raise capital quickly in the current environment due to low bank valuations.

Basel-III refers to advanced capital norms all banks worldwide needs 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 per cent and Common Equity Tier-1 (CET1) capital of 5.5 per cent. A Firstbiz analysis of capitaline data shows that at least five government banks have Tier-I capital adequacy less than 8 per cent.

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

Moody’s assumption on capital requirements at this level is based on two premises - recovery in the economy and the decline in the non-performing assets (NPA) levels of banks from the current levels. The capital requirements can overshoot the estimates if these assumptions aren’t met.

And the chances of that can’t be ruled out for two reasons:

Firstly, the decline in the chunk of bad loans in the banking system, as expected by Moody’s, may not take place at the pace at which optimists predict since the root causes of the current pile of bad debts cannot be solely attributed to a slowing economy. As Firstbiz has noted before , elements of criminality and severe rule violations are the cause of a major chunk of the big ticket stressed loans in the financial system. Kingfisher Airlines and Bhushan Steel are two such cases.

The resolution of these loans is not just the business of a commercial banker but involves investigations and judiciary, and hence is time consuming. More such skeletons are waiting to tumble out of the closet thanks to pressure from the RBI as it attempts to reduce bad debt.

Besides loans, which are categorized as bad, there is a substantial chunk of loans under the restructured loan category, which could also slip into NPA in the absence of a pick up in the economy.

In recent years, a number of firms have managed to avail the loan recast facility.

According to reports, Pawan Bansal, the middleman who got arrested by the Central Bureau of Investigation in the Syndicate bank loan bribery scam, facilitated loans from UCO Bank to Era Infra (Rs 600 crore), Tayal Group (Rs 500 crore) and Arshiya International (Rs 1,300 crore).

Aside from these, Bansal also facilitated loans from Bank of Maharashtra to these firms. This includes Rs 200 crore to Era Infra, Rs 400 crore to SEL Manufacturing and Rs 200 crore to Shiv Vani Group.

A closer look at these cases will show that many of these loans are under the stressed category in the books of banks and have been moved to the corporate debt restructuring (CDR), under which banks offer relaxed repayment terms to companies.

If these loans originated through bribes, there is a possibility that these firms didn’t deserve the bank funding through genuine channels. And it isn’t surprising that all these loans have turned into stressed ones and are under restructuring.

Bad and restructured loans result in huge capital implications for banks. They need to provide money to cover such loans and that impacts their profitability. For a loan that goes fully bad, the provision amount can go up to the full amount, while for a restructured loan, the provision amount will be 5 percent of the loan value.

According to banking industry estimates, the total amount of re-cast loans in the banking system is between Rs 5 trillion to Rs 6 trillion. The total amount of declared gross NPAs in the banking system, as of June-end, amount to Rs 2.5 lakh crore. That’s not a healthy picture for an aspiring economy.

Secondly, there aren’t any strong signals of an economic recovery yet. The latest data released by the government said India’s factory output grew by only a marginal 0.5 percent in July on a year-on-year basis, primarily due to contraction in manufacturing. Any further delay in the economic recovery would mean stress mounting on the troubled asset pile of banks as the borrowing cost of firms would stay high.

On the other hand, the stubbornly high retail inflation could potentially delay chances of a rate cut.

The conclusion: It is too early to believe that stress arising out of huge amount of sticky assets in the banking system (about 14 per cent as at end June) has begun easing or will start easing even in the next few quarters.

The government allocated Rs 11,200 crore capital to state-run banks in 2014-15. The capital implications arising out of bad loans coupled with the requirements to meet Basel-III norms, would be too much to handle for a government which is struggling to meet its budgeted deficit.

The only way, it appears, to fund the capital requirement of state-run banks, is to privatize them by bring down government stake in these entities as recommended by the PJ Nayak panel set up by the central bank early this year.

Currently, the government holds more than 70 percent stake in 12 state-run banks and over 80 percent in six. The government exiting from the majority ownership in state-run banks will give sarkari banks the much needed headroom to meet their capital needs in tough times.