Here's how to efficiently recapitalise public sector banks

The government is attempting to find a balance by being selective in its choice of banks into which to put more money.

One of the great challenges facing the Indian economy today is the gridlock that the public sector banks find themselves in.

On the one hand, the enhanced capital requirements imposed by the Basel-III norms mean that they have to raise significant more capital over the next four years; first just to reach the new norms and then to support growth in lending activity.

On the other, the burden of non-performing assets is depleting their capital, as they have to meet provisioning requirements.

Between these two, their capacity to lend is constrained, even shrinking, at a time when an economic recovery will see increasing demand for credit.

In the short term, the most practical solution is for the government to infuse more capital into the system.

But the fiscal space to do this is limited, given several competing demands for capital spending.

The government is attempting to find a balance by being selective in its choice of banks into which to put more money.

A set of financial performance indicators will reportedly be used to differentiate between banks that will receive funds and those that will be shut out.

Effectively, this means that growth opportunities will only be available to the included banks, with the others having to now worry about rolling back their asset books to accommodate lower capital bases.

Needless to say, their prospects of finding alternative sources of capital vary from slim to none.

At one level, this is a welcome step by the government.

Public resources are scarce and need to be used as efficiently as possible.

The financial and economic impact of a ‘picking winners’ approach to re-capitalise banks will be far greater than spreading capital infusions over the entire system, in which many banks are leaky buckets.

In effect, the government is signalling its intent to foster a process of consolidation within the banking system, with healthier and better-run banks being equipped to take advantage of growth opportunities, while the weaker ones fade away.

This process will unquestionably be helped by the massive retirements of employees that will take place in the system over the next five years or so.

In short, without really making it explicit, consolidation is going to be the end result of this process, with positive impacts on overall efficiency.

However, this is by no means the logical conclusion of the process.

Winners will not stay winners forever unless some significant changes are made in the governance and management frameworks within which banks operate.

To begin with, to ensure that capital is used as efficiently as possible, bank boards and managements must be fully and transparently buffered against any interference, political or bureaucratic, in their financial decisions.

In return, they must take full responsibility for their decisions and be rewarded or penalised appropriately. The transition to autonomy suggested by the P J Nayak committee provides a meaningful blueprint for this process.

Presuming that the government wants to provide a strong foundation to the banking sector, it simply cannot think of investing more capital into the institutional structure that prevails today.

This would do little more than temporarily ease the situation; worse, it would represent a waste of public money.

The other side of picking winners is fostering conditions in which they continue to win.