Some scattered thoughts could be found here.
With demonetization, banks got a surplus liquidity to the tune of Rs. 4 trillion which was largely responsible for call rates becoming tepid. However, there was no commensurate demand for credit as most corporates with a good credit rating managed to raise funds in the bond market at much lower yields. The result was that banks ended up investing most of this liquidity in government securities resulting in the Statutory Liquidity Ratio (SLR) bond holdings of banks exceeding the minimum requirement by up to 700 basis points. This combination of a surfeit of liquidity and weak credit demand can be used to design a recapitalization bond to address the capital problem. Since the banks are anyways sitting on surplus liquidity and investing in G-Secs, recapitalization bonds can be used to convert the bank liquidity to actually recapitalize the banks. Firstly, the government of India, through the RBI, will issue Recapitalization Bonds. Banks, who are sitting on surplus liquidity, will use their resources to invest in these recapitalization bonds. With the funds raised by the government through the issue of recapitalization bonds, the government will infuse capital into the stressed banks. This way, the surplus liquidity of the banks will be used more effectively and in the process the banks will also be better capitalized and now become capable of expanding their asset books as well as negotiating with stressed clients for haircuts. Recapitalization bonds are nothing new and have been used by the RBI in the past. In fact, the former RBI governor, Dr. Y V Reddy, continues to be one of the major proponents of recapitalization bonds in the current juncture. More so, considering that the capital adequacy ratio of Indian banks could dip as low as 11% by March 2018 if the macroeconomic conditions worsen, the motivation for going in for recap bonds has no logical counters. As I have often said this in many a fora, when banks talk numbers, transparency and accountability the way it is perceived isn’t how it is perceived by them, and moreover this argument gets diluted a bit in the wake of demonetization, which has still been haunted by lack of credit demand. As far as the NPAs are concerned, these were lying dormant and thanks to RBI’s AQR, these would not even have surfaced if let be made decisions about by the banks’ free hands. So, RBI’s intervention was a must to recognize NPAs rather than the political will of merely considering them as stressed assets. The real problem with recap bonds lie in the fact that the earlier such exercise in the 90s has still resulted in bonds maturing, and unless, these bonds are made tradable, these would be confined to further immaturities.