Banking operates on the basis of an entirely legal scam called “fractional reserve banking”. A customer puts his money in a bank and the bank promises to return it with interest. The bank lends the money out to another entity, and charges a higher rate of interest and lives off the difference. In case customers wish to withdraw their money, banks keep a small fraction of the deposits as a reserve.

For example, A puts Rs 100 in the bank, which will pay 5% interest. The bank keeps Rs 10 on deposit in case A wants some cash back and lends out Rs 90 to B, a stock broker, at 15% interest. Now, B gives the money to C, a trader, at 25% interest.

The bank has Rs 100 on deposit from A and it has loaned out Rs 90 to B, who has also given (the same) Rs 90 on loan to C. So, Rs 100 is doing the work of Rs 180. If all goes well, the bank receives a sum of Rs 103.5 from B, and B receives a sum of Rs 112 from C. So, fractional reserve banking can generate activity and profits up and down the line.

But if one of these deals goes wrong, somebody has to bear the loss. Ultimately, the bank must repay A, if B fails to return the principal, which may happen if C loses the money. So, the bank sets aside profits to cover potential bad loans (this is provisioning). If the bad loans are of a high volume, the bank’s owner must dip into his pockets, leading to erosion of equity.

A lot has gone wrong with the Indian banking system. Roughly Rs 9.5 trillion worth of loans are now reckoned to be unrecoverable. That is the equivalent of about 6.5% of gross domestic product (which is the sum of all goods and services produced in a country in a year). The banks have to cover those losses. This will erode their equity.

Public sector banks in the red

Most of the banks that have lost serious money are owned by the government. The public sector banking sector is responsible for about 70% of the outstanding credit in the banking system and over 90% of bad loans. Many public sector banks are technically bankrupt – their equity would be wiped out if they covered all the bad loans.

Now, there are strict global norms for the ratio of net worth (equity and reserves, which generally consist of accumulated profits) to loans outstanding for banks. Those norms are to ensure that banks do not default. This can lead to a peculiar situation where a bank has deposits to spare but cannot easily lend out that money because it does not have enough net worth. This might be the case for many public sector banks because they received huge deposits during demonetisation – when people turned in their old Rs 500 and Rs 1,000 notes after they were declared illegal tender by the government in November – but their net worth is wiped out.

These norms are set by the Basel Committee on Banking Supervision, according to the Basel Accord, the third round (Basel III) of which is kicking in. Indian banks cannot do business abroad without meeting those reserve requirements. So the banks, especially public sector units, have to raise new capital to shore up net worth urgently. The consensus estimate is that at least Rs 4.2 trillion will be required to meet Basel III norms by 2019.

Gathering funds

So how does this recapitalisation work?

The government wants to sell as little equity stake as possible. It does not have much money to spare and also has to worry about the fiscal deficit (the gap between its expenditures and revenues) going out of control.

By definition, the Basel III norms have to be met by “Tier-1 Capital”, which contains a third option for funding. That is secured debt, or debentures. Debentures are “first call” instruments. If an entity goes bankrupt, debenture holders get the first chance at being paid. Other than that, debentures are very flexible.

They can have any tenure, including perpetuity, which means that the principal will never be returned. However, the agreed rate of interest (this could be zero) must be paid – again, the legal remedies for default are much stronger than with unsecured loans.

So the government intends to raise Rs 2.17 trillion to recapitalise banks by 2019. Of this, Rs 75,000 crores will be via equity. The government will pump in something over Rs 18,000 crores – this is part of an earlier commitment. Public sector banks will sell Rs 58,000 crores worth of equity stakes.

In addition, the banks will raise nearly Rs 1.4 trillion by a convoluted process involving “recapitalisation bonds”. As far as can be figured out, the government will issue these bonds. The banks will use their spare liquidity (remember demonetisation) to buy those bonds. Lending to the government does not run foul of net worth-related matters because government debt, by definition, is considered 100% safe.

So the banks will transfer this Rs 1.4 trillion to the government in return for the recap debentures. The government will then use the cash received to subscribe fresh equity for the banks, raising the Tier-1 Capital. That improves the banks’ net worth. Maybe the banks will then sell the bonds to the public.

As of now, we have no idea what interest terms and tenures those bonds will carry. All we know is that the bonds will have a sovereign guarantee because the banks are government-owned. So, there will be takers if these are sold.

Not enough?

This financial engineering will result in partial recapitalisation. But at least twice as much will be required by 2019 to simply bring public sector banks up to required Basel III levels. Even more might be required since non-performing assets (loans on which the principal or interest payment is overdue for 90 days) and stressed loans continue to proliferate. So do farm loan waivers. Plus, assuming credit growth recovers, even more money will be required for recaps – more loans will mean additional Tier-I requirements.

There is a further point. The bad loans have accumulated over the years as a result of bad processes, political interference and bad lending policies. Public sector banks are treated as instruments of political will.

There are vague assurances being made about bank reforms but those should have been put in place and articulated transparently. If public sector banks continue to operate in the same fashion as they always have, this will be just another round of throwing good money after bad.