A few days ago, the government announced a bank recapitalization to the tune of Rs 2.11 lakh crores. Banking stocks climbed anywhere between 20 to 45 per cent in a single day. Markets went berserk and the Sensex hit a new all time high of 33,000 points. What then is the bank recapitalization and how does it work?

Understanding bank recapitalization

Let us understand this in a simple way. Banks have a certain amount of capital and they can lend only up to a certain amount based on their capital. If a bank had Rs 100 as capital, they can lend only Rs 10.

However, people have borrowed and have not paid, so to that extent the bank's capital adequacy starts falling. In technical terms the borrowed amount of loan that is not paid back after a certain period of time, is called bad debts or non performing assets. As the situation of non payment or non performing assets becomes worse, banks have to stop lending, because they are unable to meet the norm of maintaining a certain amount of capital, because of erosion.

This means as a bank the ability to lend is diminished. This does not mean the bank does not have money to lend - it has plenty of money to lend from bank deposits that it receives, but, it just cannot, because capital has eroded.

Now, this was a big problem for government banks, whose books were saddled with non payment or in technical terms called bad debts or non performing assets. This meant the more nimble footed private sector banks cornered a large part of the market share from government owned banks, who were not able to lend.

How does the recapitalization bonds work?

The government now realizes that the government owned banks have to be infused with fresh capital to get back on their feet. So, it announces a Rs 2.1 lakh crore capital infusion for banks and Rs 1.35 lakh crores would come from recapitalization bonds.

Bank recapitalization bonds are the smartest way of financial engineering. Banks are flush with money from domestic deposits. So, the government will issue bonds to the banks who will subscribe to the same. The government will use that money to infuse fresh capital into banks.

Impact on fiscal deficit

Of course, the fiscal deficit would be impacted because the government would have to pay banks interest on these bonds. However, at the present rate of 6-7 per cent this maybe barely Rs 13,000 crores, which should impact the fiscal deficit. That too the full impact would be in FY 2018-19.

Having said that, the government would be happy that it is not a part of fiscal deficit, except the interest rate. However, it does increase the public debt, which sovereign rating agencies would take note.

Inflation

Bond yields have already risen following the government's decision to issue bonds. One is not certain, whether these bonds would be tradeable. Banking stocks are fired-up without any specific details on the bonds, including which banks get how much.

Government banks will begin lending all over again and this will mean additional money supply. When M3 or money supply increases we are bound to see inflation creeping in. This is going to be another hazard of the bond issue, apart from increasing the fiscal deficit.

Strange paradox

On the one hand the government talks of divestment of holdings in government companies and on the other it is investing through fresh capital in banks. This is a strange paradox. Apart from this, in smaller banks the government may end up holding more than 75 per cent stake.

Throwing good money at bad?

A question will always remain whether the government is throwing good money at bad? Will bad debts now be easily written off and defaulting promoters get away easily?

This is one reason why the government in the past may have been reluctant to infuse fresh capital into government owned banks. However, the government may also have been ceased of the fact that economic growth has suffered on account of the NPA problem.

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