A blueprint for making PSBs Atmanirbhar

By Manas R. Das

The dictionary meaning of self-reliance (Atmanirbhar) is “reliance on one's own powers and resources rather than those of others.” Accordingly, there are two ways of determining when a bank, or more specifically a PSB, is not self-reliant. The first, known as “internal scaffolding”, is one under which the loss incurred by a bank in a year is adjusted against its ‘Reserves and Surplus’ which consequently erodes its net worth even if the bank remains liquid and solvent.

The second, the “external scaffolding” kicks in when the “internal scaffolding” collapses. The “external scaffolding” involves protecting a serially loss-making bank with weakening net worth and other relevant parameters from going bust by restricting its risk-taking activities with or without capital infusion from the owner (commonly referred to as Prompt Corrective Action). A second method under this approach is ‘blanket recapitalisation’ by the owner/s, which in the case of PSBs is the government - through annual budgetary allocations.

The major constraint on the financial self-reliance of PSBs are the humongous non-performing loans, the solution to which will not be easy or quick.

Under both “scaffoldings”, the PSBs cannot be said to be Atmanirbhar or self-reliant. Therefore, the question is how to make the PSBs self-reliant as any ‘scaffolding’, real or virtual, is temporary. In this connection, the Union Budget 2021-22 proposed the privatising of two ‘unknown’ PSBs phased over a period of time. One may, perhaps, expect a few more PSBs to follow suit if the ‘experiment’ succeeds, keeping the ‘big’ five intact.

However, will this ultimately lead to the removal of the ‘scaffolding’, especially of the ‘bailout’ through government recapitalisation, be it via cash infusion or designated bonds?

Discussed here are a few unconventional measures which, if implemented, can move PSBs towards self-reliance.

Uninstalling External Scaffolding

Recapitalisation versus CoCos

Although the PSB recapitalisation programme began in the 1990s, it became vigorous from 2010-11 onwards. While up to 2009-10, the cumulative recapitalisation amounted to Rs 230 billion, during the period 2010-11 to 2017-18, it was over Rs 1,181 billion. As the majority owner, the government is naturally free to recapitalise PSBs, but the crux of the issue is, at what cost, for how long, and whether recapitalisation alone is enough. As “Trade-offs in Bank Resolution” (February 2018), an IMF Staff Discussion Note, puts it, bailouts are “too expensive, too inequitable, and too harmful to market discipline.”

Besides, the government is finding it increasingly difficult to recapitalise the PSBs through annual budgets due to the need to adhere to the stringent deficit benchmarks. Hence, the government has in recent years elected to go for (a) recapitalisation via ‘special securities’ which is budget-neutral to a major extent and (b) ‘selective’ recapitalisation. Moreover, frequent government recapitalisation lets the presence of weak banks stifle systemic efficiency.

The bailout through public recapitalisation can be replaced with a ‘bail-in’ via Contingent Convertible capital instruments (commonly referred to as CoCos). CoCos are non-traditional hybrid capital instruments. Their twin objectives are (a) loss absorption and (b) recapitalisation, when a bank ‘is’ in trouble, or when it is a ‘going concern’. CoCos can absorb losses either by converting the losses into common equity or writing down the principal, subject to activation of “triggers”, which are of three types: Mechanical or Point of Non-Viability’ or Multiple.

There are two, but contrasting, ways in which a CoCo can recapitalise the issuing bank: (a) by converting into equity at a pre-defined conversion rate, i.e., a Conversion-to-Equity CoCo which increases the Common Equity Tier1 or CET1 and (b) by writing down the principal, i.e., a Principal Write-Down CoCo which raises equity.

As per Basel III (the 2009 international regulatory accord developed in response to the flaws in regulation shown by the financial tsunami of 2008) CoCos qualify as either Additional Tier 1 (AT1) or Tier 2 (T2) capital. Low-trigger CoCos, which qualify as T2 capital, have less loss-absorbing capacity and facilitate banks in increasing their T2 capital. High-trigger CoCos are eligible for AT1 capital, and therefore, banks use these to increase their T1 capital.

Resolution Framework Needed

However, this would necessitate instituting a statutory resolution framework, which should be quick and economic, in lieu of the case-by-case method that is being followed to resolve problem banks today. While a statutory resolution framework is necessary, it is not sufficient - this should come from putting in place a risk-based deposit insurance premium system which would leash the overly aggressive behaviour of  banks –public or private. It is incomprehensible why RBI/DICGC has not yet introduced it, although the DICGC Act, 1961 allows it. There are many ways to do it. If a variable premium system is followed, some banks may save a lot in the form of premium payment if they fall into lower risk matrices.

Change Deposit Insurance Coverage

The financial independence of the PSBs will receive a further fillip if (a) they are excluded from the deposit insurance system because, anyway, they are a ‘protected’ species or (b) they are allowed to pay premium on ‘insured’ deposits ‘only’ rather than ‘assessable’ deposits as currently provided, or (c) only ‘household’ deposits are made eligible for insurance. For example, in the case of (a), during 2019-20, the PSBs would have saved over Rs 60 billion accounting for nearly a fourth of their aggregate losses. Similarly, in the case of (b), the PSBs would have saved half the premium they actually paid during 2019-20.

Reinvest Dividend

If and when a PSB declares dividend, the government may consider reinvesting the whole or part of the dividend amount due to it in the same bank, instead of writing it into the budget where the funds are fungible. This will fortify the dividend-paying bank financially.

Boosting Profit via Tax Measures

The corporate tax on banks needs to be a few basis points below that in respect of the real sector corporates. This is because (a) banks are unequivocally ‘special’, and one should not allow them, especially the PSBs which together control 63% of the scheduled commercial banks’ business (excluding RRBs), to be in the red for a long time risking systemic stability; and (b) a sizeable part of the humongous NPAs, which are responsible for the pathetic condition of banks today, sources from various exogenous reasons.

Since interest income of banks is near-dormant and is likely to remain so in the short-term, banks should strengthen their fee-based income through diversification.

This measure, which will prop up banking indices in the stock markets as well as shareholders’ value, will ultimately create a congenial environment for the government to divest its holdings in PSBs, instead of going in for fiscally unsustainable recapitalisation programmes. In the medium-term, this may pave the way for the much-discussed Bank Holding Company.

Another proposal could be to increase the depreciation rates on various IT infrastructure that the banks invest in. Besides increasing profit, this will help banks to take on the mushrooming FinTech companies.

Uninstalling Internal Scaffolding

Spurring Fee-based Business

Since the interest income of banks is near-dormant and is likely to remain so in the short-term, the banks should strengthen their fee-based income through diversification. Banks enjoy good informational economies and hence, selling third-party products such as bancassurance, mutual fund and capital-market related products provides a lucrative option. Computations reveal that during 2019-20, the 10 new private banks earned on an average Rs 6.1 billion from cross-selling which was double the average cross-selling income earned by 13 PSBs. This indicates the existence of considerable untapped potential for the PSBs to upscale their cross-selling activities and move towards self-reliance.

The major constraint on the financial self-reliance of the PSBs today are the humongous non-performing loans, the solution to which will not be easy or quick. Therefore, ways of bolstering PSBs’ finances through some unconventional means needs to be looked at. Some of the mentioned measures may necessitate amendments to a few of the existing Acts. If the Acts to convert PSBs into private banks can be amended, other less difficult Acts can also be amended.

(The writer is a former senior economist with State Bank of India) (Views are personal)