Explainer: How will the Indian government’s bank recapitalisation bonds work?

India’s banks received a considerable boost on Tuesday with the Union government deciding to inject Rs 2.11 lakh crore worth of capital into the sector. Finance Minister Arun Jaitley said the amount was unprecedented and would help put India’s banks on the path to recovery. The last few years have seen the ballooning of non-performing assets – or loans gone bad. This has made it hard for banks to offer more credit or attract investment, even as the economy struggles to get back on track.

By infusing capital, the government is trying to partially improve the balance sheets of public sector banks, which could pave the way for them to be sold. This will also help banks write off some of the Rs 10 lakh crore bad loans currently on their books. The government is hoping to do this primarily through recapitalisation bonds, although it has yet to explain exactly how this instrument will work. With details still to be made public, questions remain about how effective these bonds will be and what impact they could have on India’s fiscal deficit.

What did the government announce?

Over the last few years, banks have been facing a serious bad loans crisis. When banks lend money, their loans count as an asset, since they will receive interest from the borrower and expect to have the original amount paid back in full. A loan becomes a non-performing asset when the borrower defaults on the repayment for more than nine months. When a bank writes off NPAs, its capital is likely to be eroded and limits its ability to lend further.

As of 2016-’17, the pile of bad loans given by Indian banks stands at nearly Rs 10 lakh crore –
larger than the Gross Domestic Product of many countries. The damage this is causing to public sector banks could be partially offset by giving them more capital. This is what the government is hoping to do with this scheme: hoping to help banks write off a percentage of their bad loans and improve their balance sheets.

The Rs 2.11 lakh crore capital infusion into the banking sector will come over the next two years, Jaitley said. It will come in three parts. The government itself will directly pay banks Rs 18,000 crore by buying their shares. It will also encourage banks to raise Rs 58,000 crore from the market. But the bulk of the amount – Rs 1.35 lakh crore – is expected to come from recapitalisation bonds.

What is a recapitalisation bond?

A bond is a financial instrument used to raise money from the markets. If someone buys a government bond, for example, they hand over a certain amount of money in return for regular interest payments along with the expectation that the government will repay the amount in full at a certain point of time. In a way, it is like giving a loan to the government.

However, bank recapitalisation bonds are slightly different. These are bonds issued by the government to which banks can subscribe – and they are specifically aimed at banks that have a lot of deposits on hand. According to Reserve Bank of India estimates, the total excess deposits accrued to the banking system due to demonetisation was in the range of Rs 2.8 lakh crores to Rs 4.3 lakh crore. It is these excess deposits that the banks are expected to use to buy the recapitalisation bonds.

They government is likely to use the money raised by the sale of these bonds to increase the number of shares it holds in the banks. This will give the banks more capital to work with, making it easier for them to offset the effect of writing off bad loans.

Meanwhile, the bonds could even be marketable, meaning the banks could put them out into the market to raise even more money.

There is one caveat here: The government has not explained exactly how the recapitalisation bonds will work. Although India has used them in the past, Tuesday’s announcement came with a promise that the government will soon explain the technicalities of its current approach.

Is this enough?

While banking analysts agree that putting more capital into stressed banks is a positive thing, nobody is sure exactly how much good it will do. Udit Kariwala, senior analyst at India Ratings, said that the last time the rating agency crunched the numbers, it came up with a requirement of about Rs 1 lakh crore for public sector banks, assuming a growth rate of 5%.

On the other hand, estimates suggest that the public banks would require about Rs 2.3 lakh crore of capital if they are to fulfil the requirements under Basel III norms on improving efficiency and transparency in the banking system. The norms, which are voluntary, are supposed to be met by 2019.

This will not be the first time a capital infusion will take place through such bonds. In the late early 1990s, after banks faced a serious financial crunch owing to indiscriminate lending to the private sector, India issued similar bonds. They were first issued as non-marketable securities and some of them were later made marketable.

How will it impact India’s fiscal deficit?

Under International Monetary Fund conventions, recapitalisation bonds are not added to the accounting of the fiscal deficit, because they are offset by buying shares in banks. In India, however, they have in the past been taken into account, since the government will have to pay interest on the bonds and eventually repay the entire amount. Jaitley said on Tuesday that the question of whether they will add to the deficit will depend on who is issuing the bonds and what their nature is, so this question is yet to be answered. Either way, the interest paid out on the bonds is likely to be added to the deficit as soon as they are bought, since that will come from the government.

The recapitalisation is also expected to shore up the balance sheets of the banks, thereby making it easier to divest their shares. Further, the assumption could also be that the recapitalisation will help the banks improve their business, leading to higher profits. This would in turn lead to higher dividends for the government for the capital it would infuse, offsetting the interest burden from the recapitalisation bonds. “In any case if the bonds are intended to be issued for the purpose of strengthening the banking system itself then it will go in the larger interest of the economy,” Jaitley said.

But analysts are still waiting for the fine print before taking a call on how successful they expect the move to be. “One needs the fine print to judge what will the bonds look like and how they will function but that hasn’t been released yet so it’s a little bit of shot in the dark for now,” said Kariwala.