Re Capitalization of Banks

Finance Minister’s announcement in Union Budget 2016, for providing Rs. 25,000 crores towards capitalization of Public sector Banks, has sparked off a debate about adequacy of this amount. In this context it is important to understand what is Bank capitalization per se and its ramifications. As this blog is primarily meant for persons who have not been exposed to technicalities of Banks and Banking operations, the underlying issues are sought to be discussed in simple terms.

‘Capitalization’ of a company broadly refers to resources infused in the Company for acquiring assets or for its operations. Capital can be issued with varying terms of face value and premium. But for the limited purpose of this blog, structuring and terms are not very relevant and Capitalization can be assumed to mean aggregate funds infused as Capital to run the show.

For a Bank, Capital  is classified under Tier I or core capital and Tier II or supplementary capital. Tier I capital consists of shareholders' equity and retained earnings. Tier II Capital includes revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves etc. Tier I capital is taken as a measure of Bank’s real financial health, and its ability to survive business shocks.. Under an international agreement , known as Basle accord, Banks are required to maintain a certain percentage of capital (percentage to assets). So if the Banks wish to grow and add more assets (for a Bank its loan portfolio is asset while the deposit it collects is liability) it needs additional capital. Similarly a Bank may need additional capital to offset the impact of losses/provisions for doubtful loans, as these provisions have to be made from accumulated earnings which form part of Tier I capital.

So if the Bank has to grow then it needs additional capital, and if it has to be insulated against bad loans then also it needs additional capital. Since the Banks already have capital or they are already capitalized, fresh infusion or topping up of capital has come to be known as Re Capitalization.

Re-capitalization can take place for a variety of reasons, but its primary aim is to maintain Tier I Capital ratio in terms of Basle accord.

Banks collect deposits and lend part of this money at a higher rate of interest, so as to pay interest to the depositors as well as earn profits. Since Banks have to maintain a certain capital adequacy ratio ie ratio of capital to assets, Networth becomes a benchmark for determining the extent to which a Bank can lend.  Weak capital impacts its ability to lend, which in turn reduces profits. Lower profits mean lower retained earnings, further weakening net worth. So a weak capital structure pushes the Bank into a vicious cycle of overall weakness and may ultimately lead to its collapse. The situation gets compounded, when some of the money lent by the Bank turns into a bad loan ie stops earning profit for the Bank, In a sense it becomes dead asset. So now the Bank has to earn profit from a lower asset base, further stressing the cycle.

This vicious cycle can be broken and turned into a virtuous cycle by infusing fresh capital into the Bank (meaning recapitalization) . With this fresh capital, Bank becomes stronger, is able to attract more deposits (even cheaper deposits), is able to lend more, is able to earn more interest on these increased loans and the increased profit improves its networtth further as retained earnings. So recapitalization essentially means strengthening the Bank so that it becomes more healthy and profitable.

Government has a vital interest in financial health of Public sector Banks (PSBs), not only because it’s a majority shareholder but also because well-being of banking sector is very important for overall economic health of the country. Public sector Banks command about 73 % share in banking business in the country, so it becomes imperative to ensure that these Banks are in good health. So adequate capitalization of Banks, becomes an instrument of economic policy.

Adequate capitalization or Re capitalization becomes necessary when Banks become weak on account of erosion of networth due to provision for bad loans. This capital can either be infused by the Government , being virtual owner as majority shareholder of these PSBs or minority shareholders ie public can also be approached. In August 2015, Government had estimated that Rs. 1.80 lac crore would be required for recapitalization of Banks in next 4 years till 2019, to meet capital adequacy norms as per Basle III accord. Out of this, Government planned to invest Rs. 70,000 crore while the Banks were expected to raise the residual Rs. 1.10 lac crore from market sources. Government’s contribution of Rs. 70,000 crore was to come in four tranches, out of which Rs. 25,000 crore was invested in FY 2015-16 and another Rs. 25,000 crore has been budgeted for investment in FY 2016-17. These investments are through a preferential allotment of equity shares to the Government at market related prices.

For the residual Rs. 1.10 lac crores there is an option to go to the public, which are the other shareholders apart from Government. But when the Bank’s Balance sheet has been hammered by provisioning for bad loans and public perception is down, general public response may be poor. So the best available option is to garner resources from informed investors who understand technicalities of long term investment in Banking sector better than general public. This can be done through Qualified Institutional Placement (QIP) offer. A QIP offer is a mechanism whereby a Company listed on the stock exchange can sell securities to institutional investors. For example, market regulator SEBI had in March 2016 permitted  IDBI Bank to raise Rs.3,771 crore through the QIP route.

In the end, it should be remembered that recapitalization is not meant for improving Bank’s liquidity but to improve its strength. Liquidity can be improved, if the Bank borrows from other Banks or institutions on the basis of Government’s sovereign guarantee, but it will only add to its debt liability without improving its strength or networth. So recapitalization helps in improving Balance sheet of the Bank without increasing its liability.