The news that recapitalization of public sector banks with a sum of Re 2,11,000 Crores by public release of a news item by the Central government to clean up the legacy of Non- Performing Assets, to spur credit growth to MSMEs for jobs and growth for the economy, and a push to credit off take in all sectors attracted my attention since RBI Deputy Governor, Mr. Viral V Acharya touched the effect of non- capitalization or in adequate capitalization for banks in other countries under similar conditions in earlier decades in his speech dated September 7, 2017 delivered at the 8th R K Talwar Memorial Lecture organized by the Indian Institute of Banking and Finance at Hotel Trident, Mumbai…
Let us analyze his speech which would open up our minds towards the future of the present banks in India with a huge NPAs which grow every other day due to RBI/Other Audits and also failed to lend other genuine borrowers for want of funds. The complete speech is covered in RBI website as under:
Now the analysis of his speech:
“In a recent study from the Bank for International Settlements, Leonardo Gambacorta and Hyun-Song Shin (2016) document that bank capitalization has a strong effect on bank loan supply:
a one percentage point increase in a bank’s equity-to-total assets ratio is associated with a 0.6 percentage point increase in its yearly loan growth.
In fact, if a banking system remains systematically under capitalized and new lending is not kept under a tight supervisory watch, then the economy can suffer significantly from a credit misallocation problem, now commonly known as ‘loan ever-greening’ or ‘zombie lending’.
In particular, under capitalized banks have an incentive to roll over loans from financially struggling existing borrowers so as to avoid having to declare these outstanding loans as non-performing. With these zombie loans, the impaired borrowers acquire enough liquidity to be able to meet their payments on outstanding loans.
Banks thus avoid the short-run outcome that these borrowers might default on their loan payments, which would lower their net operating income, force them to raise provisioning levels, and increase the likelihood of them violating the minimum regulatory capital requirements.
By ever-greening these loans, banks effectively delay taking a balance-sheet hit, while taking on significant risk that their borrowers might not regain solvency and remain unable to repay, now even larger loan payments. While unproductive firms receive subsidized credit to be just kept alive, loan supply is shifted away from more creditworthy firms.”
Now the story of the banks in other countries through the ages, nay, decades.
The Japanese story:
Let us study European story which literally tailed the Japanese saga.
The European story
“This vicious cycle of poor bank health and sovereign indebtedness became a matter of great concern for the European Central Bank (ECB), as this cycle endangered the monetary union as a whole. As a result, the ECB began to introduce unconventional monetary policy measures to stabilize the Euro zone and to restore trust in the periphery of Europe.
Especially important in restoring trust in the viability of the Euro zone was the ECB’s Outright Monetary Transactions (OMT) program, which ECB President Mario Draghi announced in his famous speech in July of 2012, saying that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Post OMT scenario
“Post OMT, expectedly the bond yields fell and the assets side of the banks’ balance sheet improved but even then, financially weak banks continued to finance borrowers at a cheaper rate of finance as compared to borrowers from countries like Germany who paid higher interest for their loans. This is similar to zombie lending and hence zombie borrowers were created.
In particular, healthy firms in industries with an average increase in the proportion of zombie firms invested up to 13% less capital and experienced employment growth rates that were about 4% lower compared to a 10 scenario in which the proportion of zombies stayed at its pre- OMT level.
At extremis, for an industry in the 95th percentile increase in zombie firms, healthy firms invested up to 40% less capital and experienced employment growth rates up to 15% lower.”
This situation arose because of under capitalization of weaker banks.
Let us go back to our original issue of adequate capitalization by the Central Government of the public-sector banks. The economic pundits agree that this decision has been wisely taken.
Central Government expects the following in addition to infusion of fresh capital unlike the happenings in Japan or Europe.
Definite steps will be taken alongside capitalization to enable Public Sector Banks having 70% market share in the banking space to contribute through enhanced credit off take.
The expected steps are: I have simply put the public announcement of the Central Government verbatim:
The public announcement of the Central Government about infusion of unheard of amounts of capital resulted in the research of the previous economic history of countries like Japan and European nations. I could find a speech given by Mr. Viral V.Acharya, Deputy Governor of RBI. The relevant facts have been given in my article. It is expected that having learnt from history, India will lift our banking system from sick category to profitable one which would usher in great offtake of credit and resultant economic miracle.
Acharya, V.V., T. Eisert, C. Eufinger, and C.W Hirsch (2015), ‘Real effects of the sovereign debt crisis in Europe: Evidence from syndicated loans’, CEPR Discussion Paper No 10108.
Acharya, V.V., T. Eisert, C. Eufinger, and C.W. Hirsch (2016), ‘Whatever it takes: The real effects of unconventional monetary policy’, Working Paper, New York University Stern School of Business.
Acharya, V.V. and S. Steffen (2014), ‘The greatest carry trade ever? Understanding Euro zone bank risks’, Journal of Financial Economics 115, 215–36.
Bain & Co and Institute of International Finance (IIF) (2013), Restoring Financing and Growth to Europe’s SMEs, Washington, DC.
Caballero, R.J, T. Hoshi, and A.K. Kashyap (2008), ‘Zombie lending and depressed restructuring in Japan’, The American Economic Review 98(5), 1943–77.
Gambacorta, L. and H.S. Shin (2016), ‘Why bank capital matters for monetary policy’, Working Paper.
Giannetti, M. and A. Simonov (2013), ‘On the real effects of bank bailouts: Micro evidence from Japan’, American Economic Journal: Macroeconomics 5, 135–67.