Sunday, November 1, 2015

Capitalization of PSU Banks - (Hindu News Analysis - 4)

Recently, the central government proposed to inject Rs.15,000 crore of capital in PSU banks in an effort to handhold these PSUs tide through the difficult period(rising NPAs) with a hope that they will recover soon. 

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News Analysis


Commercial banks need capital to grow. Capital adequacy requirements asks all banks to keep a minimum amount of shareholder capital(also called equity capital) in proportion to their balance sheet size. Currently, in India this requirement is 9% of "risk weighted assets" of banks. It means that banks are expected to have equity capital which is 9% of their commercial loans. 
As banks grow their business, their risk weighted assets also grow. This means that banks have to increase their equity capital base in line with the growth of their loan book. 

Such increase in capital can come from exactly two sources:

  • Retained profits that are added to the capital base
  • Fresh infusion of equity capital from shareholders. 
In India, given the overall profitability of the banks (~1.1% return on assets) and the amount of dividend that they pay (~20%) of post-tax profits, banks do not have enough retained profits to support their business growth. Therefore, every now and then, they go to shareholders to raise fresh capital.



Govt. of India is a the majority shareholders in all PSUs. Since the government wants to maintain its ownership at 51%, it has to supply atleast 51% of the fresh capital that PS banks need. [Note: If someone else provides equity capital to PSU, his/her shareholding will increase and govt's shareholding will decrease, which the govt. would not want.]



Capitalisation of PSUs bank

1. Bad Investment for Govt. - Fiscal Challenge for economy
  • The Indian government currently borrows money over long term period at over 8%. 
  • The dividend yield on PS banks shares has been between 2% and 3% over the last decade. This means that the government earns between 2% to 3% on its investments in PS banks, because govt. is the shareholder and they get dividend payout. 
  • Hence there is a 5% “negative carry” or loss that government bears on these investments. 
Hence capitalisation of PSUs is a bad investment for govt.

2. Impact on competitive dynamics of banking industry
Private banks are under constant scrutiny of investors and analysts. When they go to external investors for raising capital, they have to satisfy investors on number of critical aspects of the business - profitability and its sustainability, efficiency of capital use, quality of management team, cost efficiency, etc. In other words, private banks face a market test and  they do not get capital for free. Only well run private banks get equity capital that is required for growth.

None of these questions get asked when government puts capital into a PSU bank. One has never heard a senior government official commenting on the Return on Asset (RoA) or Return on Equity( RoE) of PS banks. The decision to put capital into PS banks is treated as a mechanical and administrative decision. 

This absence of a market test has systemic consequences. PS banks have ~70% share of the Indian market. When the majority owner is asking no or very few questions on performance, and is assuring an almost unlimited supply of capital, these banks have little incentive to improve financial metrics such RoA and RoE. This hurts the overall banking industry. For example, PS banks can under-price loans compared to their private sector peers. Such behaviour would migrate the whole business to lower returns. It is hard for a private bank to be profitable when facing rivals that are not concerned about return on capital. 
[Note: No wonder we have such a huge NPAs piling up in PSU banks.]
Analogy: Kingfisher example - As long as Kingfisher was around, with an artificially low cost of capital, this exerted downward pressure on air fares, and hurt all healthy airlines. The exit of Kingfisher was of essence in bringing the rest of the industry back to health. 
3. Obsession of Indian govt. with majority shareholding - 51%
It seems that the whole capitalization issue is to do with the government's obsession with retaining majority (over 51%) ownership of PSU banks. This is often explained in terms of the need to maintain the "public sector character" of these banks.

All PSU banks are not companies under the Companies Act. The notion of 51% giving majority control is mandated in the Companies Act. PSU banks were created under the Nationalisation Act (SBI has its own SBI Act). The Nationalisation Act provides the government undisputed control over the PSU banks. While it does prescribe 51% government ownership in the PSU banks, the control of government is independent of the level of its ownership. There is no chance, therefore, of any external shareholder acquiring control in these banks. Even relatively minor changes to the functioning of PS banks require approval of the parliament. Hence there is then no question of diluting the public sector character if the government ownership were to drop to, let's say 26%, which is the threshold for "significant" minority stake in a company.

Conclusion

In the long run, therefore, it makes no sense for the government to commit itself to the capitalisation of PSU banks. Precious government resources can be better deployed in critical areas (such as power transmission and distribution) where private capital on large scale is hard to come by.

It also makes sense for govt. to get over the majority obsession, explain to all the stakeholders the fallacy of this obsession and the resulting pressure on public finance, then build a political consensus to enact necessary legislative changes and then dilute down to a reasonable level.