Recapitalisation and Demonetisation. Is the link exaggerated?

What has been witnessed in the aftermath of demonetisation is the declining yield on Government securities, and as a consequent of which treasury gains for public sector banks have already surpassed capital infusion. With a sluggish economy, high levels of stressed assets and eroding bottom-lines, banks have been pushed to the corner to regulate lending. The aim of recapitalisation, and/or capital infusion is geared towards shoring up the lending capacities of banks, public sector banks in this case as countenance  against these erosions. To understand what recapitalisation is, let us take a jaunt to Indradhanush 2015, the seven colours or A2G meant for reviving the banking industry in the country. The seven colours talked about are: Appointments, Bank Board Bureau, Capitalisation, De-stressing PSBs, Empowerment, Framework of Accountability, and Governance reforms. The third colour, i.e. capitalisation (Capital Infusion or Recapitalisation) is an exercise to estimate the capital requirements based on credit growth rate of 12% for the current year and 12 to 15% for the next three years depending on the size of the bank and their growth ability. It has been presumed that the emphasis on PSBs financing will reduce over the years by development of vibrant corporate debt market and by greater participation of Private Sector Banks. Based on this exercise, it is estimated that as to how much capital will be required this year and in the next three years till FY 2019, despite the banks being under a lot of stress and still adequately capitalised and meeting all Basel-III and RBI norms. It must be noted that under Basel III, a bank’s tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5%. The capital conservation buffer recommendation is designed to build up banks’ capital, which they could use in periods of stress; where tier-1 capital is the core capital and includes equity and disclosed reserves, while tier-2 capital are hybrid capital instruments, loan-loss and revaluation reserves as well undisclosed reserves.

After excluding the internal profit generation which is going  to be available to PSBs (based on the estimate of average profit of the last three years), the capital requirement of extra capital for the next four years up to FY 2019 is likely to be about huge amount of Rs.1,80,000 crore.

Out of the total requirement, the Government of India proposes to make available Rs.70,000 crores out of budgetary allocations for four years as per the figures given below:

(i) Financial Year 2015 -16 Rs. 25,000 crore
(ii) Financial Year 2016-17 Rs. 25,000 crore
(iii) Financial Year 2017-18 Rs. 10,000 crore
(iv) Financial Year 2018-19 Rs. 10,000 crore
Total  Rs. 70,000 crore

According to the document itself, PSB’s market valuations will improve significantly due to (i) far-reaching governance reforms; (ii) tight NPA management and risk controls; (iii) significant operating improvements; and (iv) capital allocation from the government. Improved valuations coupled with value unlocking from non-core assets as well as improvements in capital productivity, will enable PSBs to raise the remaining Rs. 1,10,000 crore from the market.  Moreover, the government is committed to making extra budgetary provisions in FY 18 and FY 19, to ensure that PSBs remain adequately capitalized to support economic growth. The banks can raise capital from the capital markets as well be availed of tranche facilities running over three tranches, and nowhere is there any mention of such budgetary allocations meant for capital infusion or recapitalisation on the substitute for the process of demonetisation. Before moving on to demonetisation, it must be remembered that capitalisation, recapitalisation or capital infusion (the first two are generally used interchangeably and depends on who the user is, with the former lying squarely with the banks, while the latter with academics, if that wasn’t too generic a distinction, I be forgiven!) is through budgetary allocations. Let us underline this.

Demonetisation is when the Central Bank, RBI in our case strips the bill of its legal tender. What happened post November 8 was stripping bills of Rs. 500 and Rs. 1000 of their legal tender, thus rendering them invalid.

Almost everyone seems to be collaging demonetisation and black money, terror funding, illicit and counterfeit money flows. Not that there isn’t correlation between these, but the whole of argumentation is getting reducible to these aspects and what seems to be totally sent to oblivion is tax evasion. Though, some talks do touch upon these, many of these commit the folly of citing tax havens like Mauritius and Singapore and black money hoarded and channeled through there. A populist line of thought, without considering the fact that a recently concluded tax treaty between India and Mauritius has choked the tax haven significantly. One with Singapore is in the pipeline, and once that gets concluded, the two tax havens would then need to seep through populist discourse as no longer the culprits before the narrative changes sense. A tall order from a half-baked recipe.

On the other hand, even if terror funding is caused by higher denominations, one shouldn’t belittle other ingenious ways of carrying out the same. Though, flushing the economy of higher denominations could trickle down to curbing such illicit fundings, the government should not be gung-ho over this as the be-all end-all to choke such flows, for such denominational crushes would only exaggerate Kosher funds, funds through oil economics, extortion and crucially politically-motivated funds slipping through religiously-fundamentalist and right-wing techno geeky consortiums.

So, whether the move is short-term distress or long-term satisfactory should not be decided on subjectivities, but rather on economic complexities, the answers to which sadly the Government doesn’t have at the moment and no wonder crying foul over any resistances to its move. The same goes true for even those calling the government to dock, for the problem is economics should not be totally (read: wholly) studied sociologically anymore, but all the more importantly, sociology needs to be studied as a consequence of economics, and once the order goes for a tailspin, its only fertile for such sentimental concerns, not that anythings wrong with such concerns, but for the fact these have tendencies to become authoritarian. By authoritarian, what is meant is surely Prime Minister’s grand designs. Unlikely entities in the form of Ratings Agencies is stifling PM’s grand designs. But, all of that could change. With demonetisation of notes and GST, hopefully not this quarter but over the next six-seven quarters, there will be an improvement in the fiscal debt-to-GDP ratio by virtue of expansion of denomination, and improvement in the fiscal tax-to-GDP ratio by virtue of better tax collection. Meaning, a possible upgrade from Baa2 (Moody’s) and BBB- (S&P), a notch over the junk. Consequentially, it’d mean all the big three seeing this war on people capitalistically profitable. a sort of double bind, ain’t it? And, here I am guilty of parsimonious arguments, for reasons that most of these are in liberal supply on the media. So, the basis is to look out at connectors and/or disconnectors between recapitalisation and demonetisation, which is still within approaching distance from here on.

With demonetisation has come massive exchanging of old currency for new denominations of Rs. 2000 and Rs. 500 on one hand and depositing old currency in accounts till 30th of December 2016. The deposits have spiked and banks are faced with surplus liquidity, which they are finding hard to find avenues to disburse, say in the form of investments. The cause, which has been reactionary has left the effect no less reactionary, and the culpability lies squarely with planning and implementation of the scheme. Well, thats a different matter, and thus at best put aside. But, the fractures within the social fabric caused due to this lack of implementation has had fatalities that have been extremely costly. As the Financial Express was prescient in noting, there was ecstasy with deposits rising just at beginning of the busy season. Consumerism had shown strong signs in the period leading to Diwali and the good times were to come along supported by banks, which were running tight on deposits. In fact, RBI has been supplying funds through OMOs all through, and it is against this background that banks became ecstatic as deposits rolled in. Most households were in a panic mode and were just keen on getting rid of old notes safely and, hence, most of this money went into savings deposits. The consequences were significant. First, banks automatically started lowering the deposits rates as they no longer had to wait for RBI to announce changes in the repo rate. This also meant that the lending rates could be reduced without a prod, which was a win-win situation for the system. The transmission mechanism became smooth under the compulsion of market forces. In fact, some sections of the market believed that RBI need not lower the repo rate in the December policy, as circumstances have already delivered the result unobtrusively. Banks were also pepped up as the G-Sec yields had crashed with the 10-years paper going down to 6.3% with sentiment providing a guidance of sub-6%. This meant there were capital gains to be had, which would prop up income and banks would be better able to manage provisioning for their NPAs. But, the downside is that the banking sector does not have the capacity to absorb so much of liquidity, and with a low demand for credit, the alternative is to approach G-sec (Government Securities) market. Now, the catch. With stringency to the fiscal target, having additional paper in the primary segment would be self-defeating, and thus another turn, which happens to be the secondary segment for banks to target. This has led to the yields coming down sharply. Given that banks have been paying a minimum of 4% interest on deposits, a positive net return is what they would have wanted. The reverse repo window has been used widely to park these funds where the return could go to 6.25%, which would just about cover their operating cost to assets ratio of 2-2.5%.However, RBI has limited G-Secs in its balance sheet, which is around R7.5 lakh crore, and in case deposits do shoot up to R10 lakh crore, it would not be possible to satiate the market. One option is seeking recourse to MSS bonds (market stabilisation bonds), which have been used in the past when money supply increased mainly due to the influx of foreign currency in the system leading to sharp appreciation in currency. But given the quantum involved (between Rs. 5-10 lakh crore ultimately if the target is reached and cannot be used for lending), this would push up government debt substantially. In fact, it will also add directly to the fiscal deficit, which is not acceptable.

So, what has the RBI proposed? Locking in liquidity on an ex-post basis. It has increased Cash Reserve Ratio (CRR) by 100% of net demand and time liabilities (NDTL),  which is the difference between the sum of demand and time liabilities (deposits) of a bank and the deposits in the form of assets held by another bank. Formulaically,

NDTL = demand and time liabilities (deposits) – deposits with other banks.

The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors. CRR is a crucial monetary policy tool and is used for controlling money supply in an economy. towards the end of November, the RBI hiked the incremental CRR by 100%. The incremental cash reserve ratio (CRR) prescribes the reserve ratio based on the extent of growth in resources (deposits). It im­mobilises the excess liquidity from where it is lodged (the banks which show high growth), unlike the average ratio which impounds from the banks which are slow-growing as well as banks which are fast-growing. It also avoids the jerkiness of the average ratio. This means it has literally mopped the surplus liquidity that has gone into the banks as deposits in the wake of demonetisation. So, banks do not have capital to lend.  There is a formula on how much a bank could lend. It is:

Lending = Deposits – CRR – SLR (statutory liquidity ratio) – provisioning

; SLR is the amount of liquid assets such as precious metals (Gold) or other approved securities, that a financial institution must maintain as reserves other than the cash.
Formulaically,

SLR rate = (liquid assets / (demand + time liabilities)) × 100%

As of now, the CRR and SLR rates are 4% and 23% respectively. Hence, the bank can only use 100-4-23= 73% of its total deposits for the purpose of lending. So, with higher CRR, banks can give less money as loan, since with higher interest rates, it becomes expensive to lend. This can curb inflation (and this is one of the main arguments of pro-demonetisation economists), but may also lead to slowdown in economy, because people wait for the interest rates to go down, before taking loans.

To reiterate: This move by RBI was necessitated by the fact that the central bank at present holds Rs 7.56 lakh crore of rupee securities (G-Secs and T-Bills) and will soon run out of options of going in for reverse repo auctions, where it sells G-Secs in return for cash from banks, which have surplus deposits. These transactions have been reckoned at rates between 6.21%-6.25%. There are expectations that the volume of deposits will increase by up to Rs10 lakh crore by December because of the demonetisation scheme. The present equation of Rs3.24 lakh crore impounded by CRR and Rs7.56 lakh crore to be used as open market option (OMO) or reverse repo auctions broadly covers this amount, leaving no extra margin. There are two implications out of this: One being, as the level of deposits keep increasing, banks may have to park the increments as CRR with RBI which will affect their profit and loss (P&L). The expectation till today morning had been that the RBI would lower the repo rate aggressively in the December policy by 50 basis points (bps), i.e. today, which it did not do. This surely is deferred till stability due to demonetisation is achieved in the system. The other being on interest rate transmission. Banks could have delayed cutting their lending rates given that they had promised at least 3-4% interest rate to savings account depositors, and not be receiving any interest on the deposits impounded for CRR, which they haven’t as on individual levels, they have been cutting lending rates to approach RBI rates. This culminates into liquidity to tighten and send bond yields on a northward blip, and this is where lending would shrink automatically. And, that is the connector spoken about above, where when the lending spigots are tightly controlled due to tightening of liquidity, the logic behind capital infusion, which anyways comes in through budgetary allocations gets defeated. The real constraining factor could arise when Large Exposure Framework (LEF) gets kickstarted next financial year confining banking sector’s exposure to highly leveraged corporates through a cap scanning risk environs along the way. But, these consequences are still in a speculative realm, though definitely geared to life via demonetisation. 

 

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