Desperate times call for desperate measures. And it is clear that the capital adequacy problems dogging public sector banks are beginning to cry out for some desperate measures.

Today, estimates of capital requirements for the beleaguered public sector banks to meet Basel III norms range upwards of ₹2.4 lakh crore over the next three years. The Centre is hard-pressed to meet this requirement.

After providing under ₹8,000 crore towards bank recapitalisation in the previous budget and getting a lot of flak for it, it has since raised this commitment to a mammoth ₹70,000 crore.

But sector watchers have been pointing out that even this is woefully inadequate. Given the string of quarterly losses being posted by the state-owned banks of late, the Centre cannot be seen dragging its feet on the issue, as that would be toying with public confidence in the banking system itself.

The nineties solution

One (desperate) solution, if the FM is willing to a leaf out of the history books, lies in a bit of financial engineering employed by the government (of the day) in the nineties.

It goes like this. In the early nineties, nationalised banks in India saw a severe erosion in their profitability and capital base after their untrammelled lending to the priority sector in the preceding decade. This prompted the cash-strapped government to come up with a novel strategy to shore up the banks’ capital without an immediate demand on its budgetary resources.

It simply borrowed from the banks themselves to meet their capital requirements! To do this, it issued several tranches of special non-marketable securities called “Recapitalisation bonds” to the nationalised banks. The banks subscribed to these bonds in the normal course of their business.

The cash thus raised was used by the government to infuse fresh ‘equity’ into the beleaguered banks. Initially issued for a specified period, these bonds were later converted into marketable securities or into perpetual bonds, by mutual agreement between the banks and the Centre.

According to one estimate, as much as ₹20,000 crore was infused into public sector banks through this method between 1985 and 1995.

While the government was merely postponing its obligations through these bonds, this move did not result in undue fiscal burden over the long term, as the Centre earned both dividends and market returns on bank shares.

The pluses

The advantages of a bailout using such recapitalisation bonds are many. One, the government need not raise immediate tax revenues to fund the mammoth bill on bank recapitalisation, which means less burden on the taxpayer.

Two, by borrowing directly from the banking system instead of the markets, the Centre can avoid crowding out private borrowings or distorting market yields.

The fact that there is no such crowding out can justify keeping them out of fiscal deficit measurements too. (To make this effective, banks need to hold these bonds for the long-term and not liquidate them in the markets). Three, as the Centre can borrow at far cheaper rates than the distressed banks, this would be an economical way to raise funds.

From the banks’ point of view, subscribing to the Recapitalisation Bonds does not really strain their finances, because lending to the Centre is about the safest thing they can do with their loan funds. In any case, public sector banks tend to invest well in excess of their Statutory Liquidity Ratio requirements in government securities.

As long as interest rates on these bonds are transparently pegged to prevailing market yields, banks will not suffer any opportunity loss on income either. Getting go-aheads for the bond issue from RBI and SEBI would take care of the regulatory aspects.

Financial engineering?

But is such a solution really above-board? Isn’t it financial engineering? No doubt it is, but it can be considered in the interests of the economy, if it is transparently done. Whether the Centre borrows from the market or does so from banks themselves, this move will bloat its borrowings quite significantly. This will escalate the nation’s debt-to-GDP ratio and will cause rating agencies to look askance at it.

But the negative impact can be mitigated to some extent, if the entire process is managed transparently, and the financial impact disclosed upfront.

Given that global central banks have resorted to quite a large number of creative instruments in recent years to bail out their banks, the rating agencies will find it difficult to view this very negatively.

The other big risk to this idea is obviously that the government would be borrowing money to invest in equities (bank shares), something that no conservative financial adviser would recommend.

But, in the stock market, it is commonplace for private sector promoters to step in to acquire their company’s shares to signal confidence, if they believe the stock to be unfairly valued. As the promoter of state-owned banks, the government is entitled to do the same. Given the huge discounts to their book value at which some of these shares trade currently, this is also a bet that could pay off for the exchequer over the long term.

However, there is one very important caveat to be made on this idea. Using recapitalisation bonds can only act as a short-term, fire-fighting solution to the crisis afflicting Indian public sector banks today.

Measures like this will not do anything to address the structural rot in the banking system that has created the bad loan menace in the first place — poor governance systems, badly judged lending decisions in good times, and the repeated white-washing of doubtful accounts in bad ones.

These problems need to be addressed separately through wide-ranging reform of bank ownership and governance structures by the RBI and the Centre. Else, the easy expedient of recap bonds, used for a second time, will certainly create a moral hazard for all future times to come.