Public sector banks in India are in crisis. Saddled by bad loans amounting to Rs 7 lakh crores as of June, they are unable to provide fresh loans. Most of them are facing a capital crunch. In April, it was reported that credit growth for banks had hit a 60-year low in the 2016-2017 financial year.

To solve some of these problems, the government on Tuesday announced a plan to inject Rs 2.1 lakh crores worth of capital into public sector banks through a combination of budgetary support, market borrowings and bank recapitalisation bonds. Over the next two years, the government would directly pay banks Rs 18,000 crores by buying their shares while the banks would be expected to raise Rs 58,000 crores from the market. The remaining Rs 1.3 lakh crores would come from recapitalisation bonds.

Recapitalisation bonds are instruments issued by the government that banks can buy, using the excess deposits they have accumulated after the demonetisation of old bank notes last year. The government will, in turn, use the money thus raised to provide more capital to the banks. This would ensure the banks have adequate capital that meets regulatory requirements and allows more lending.

India’s bad loan problem is not new. Over the last few years, as the number of stressed assets – loans unpaid for more than nine months – rose consistently, banks expected the government to infuse capital into the system to help them tide over the crisis. But the government could do so only in a limited capacity. It launched programmes like Indradhanush in 2015 – which promised to pay state-run banks Rs 70,000 crores over four years – but these measures have failed to get rid of the high bad loan ratio and rejuvenate the banking system.

The government now intends to infuse Rs 2.1 lakh crores into public sector banks – an amount most experts deem adequate, since their estimate of the banks’ requirement is around Rs 1 lakh crores. However, they strongly suggest that unless such an infusion of capital is accompanied by long-term reforms, the banking system will remain hobbled with problems.

Improving credit flow

“The problem about the health of public sector banks remains and it will need to be fixed,” said Radhika Pandey, a consultant with the National Institute of Public Finance and Policy, a research body. “Unless private investment picks up, it is yet to be seen if the credit flow in the economy increases.”

A major challenge to credit growth in India is the twin balance sheet problem – where the balance sheets of banks are full of bad debt and the corporate sector struggles in a slowing economy. This problem was first mentioned in the 2014-2015 Economic Survey of India. To counter this, experts say measures must be taken, such as merging weaker banks with stronger ones.

Even the government has said that its actions will not be limited to recapitalisation and that it also intends to boost lending by public banks through a Mudra Protsahan campaign, based on the Micro Units Development and Refinance Agency or Mudra scheme that provides loans to micro, small and medium enterprises.

Awarding performance

Among other reforms, some experts suggested giving capital to banks based on their performance, in order to bring about discipline in the banking system.

“Banks need to be given capital based on the strength of their balance sheets and weak performers need to be brought up to speed,” Reserve Bank of India Governor Urjit Patel said in a written statement on Wednesday. “It will allow for a calibrated approach whereby banks that have better addressed their balance sheet issues and are in a position to use fresh capital injection for immediate credit creation can be given priority while others shape up to be in a similar position. This provides for a good way of bringing some market discipline.”

Radhika Pandey also pointed to problems in the lending policy of public sector banks. She said these institutions had allowed non-performing assets to build up as a result of their indiscriminate lending, and recommended greater vigilance on the way loans are given and to whom.

Bad loan problem too big?

However, former Reserve Bank Deputy Governor KC Chakravarty said in an interview to BloombergQuint that a capital infusion of Rs 2.1 lakh crores is “too little” when stressed assets in India’s banking system amount to Rs 10 lakh crores. “My apprehension is that it is too small money,” he said. “The NPAs of the banking system, a majority of which is with the public sector banks, is already Rs 10 trillion. Now, if you see the provisioning gap, the provisioning coverage ratio is only 40% if you see all the banks. So already there is a gap of Rs 6 lakh crores.”

Provisioning essentially means money that banks keep aside for loans that they expect to go bad. Gross non-performing assets is simply net non-performing assets plus provisioned money set aside by banks. Currently, the provisioning ratio is around 43% for all banks compared to the non-performing assets.

Anil Gupta, vice-president of the credit rating agency ICRA, agreed that there is a large provisioning gap in the banking system, but said that much of it is expected to be covered by the government’s capital infusion and the banks’ own profits. He, however, said that if the plan to raise part of the money from market borrowings does not work out well, then the amount of capital could prove inadequate to boost lending.

“The grey area is those market borrowings of Rs 58,000 crores which may or may not happen as planned,” he said.

Pointing out that long-term reforms are the need of the hour, he suggested a stricter underwriting process (by which a lender determines the risk of lending to a borrower) for loans, and merging smaller banks with larger ones.

“Banking sector reforms are required at all levels to ensure that we do not end up in the same position again after five to 10 years,” he said. “The credit cycle in the years after 1995 was also very bullish but we ended up in an NPA [non-performing assets] situation like this. Banks need to strengthen their process of providing loans so that they go to genuine buyers who can repay on time and so on.”