How to Solve the Financial Sector’s Capital Shortfall

Context: Given that PSBs account for 90% of the shortage, a credible divestment plan would reveal some well-capitalized suitors among private banks.

Issues with the Financial Sector: In the light of capital shortfall in the financial sector, certain trends have been identified since the Global Financial Crisis (GFC) of 2008

• Steady rise after GFC: peaking in 2013, which coincided with the boom-bust cycle of the bank lending that accompanies the post-GFC stimulus.
• No reversion of early GFC-phase after 2014: i.e. the financial sector is not yet on a definite path of recovery.

• This phase coincides with “silent crisis” in which credit growth for the economy has been anaemic due to 

• Zombie lending – evergreening of loans to the legacy non-performing borrowers 
• Lazy lending- simply investing in government bonds hoping for interest rates to decline 

• Impact of demonetization: The post-demonetization boom-bust cycle of NBFC lending has only accentuated this problem.

• Majority capital-deficiency in PSB: The top 15 capital-deficient entities are all in the public sector (12 PSBs, two power finance companies, and one housing finance company),

• Their capital shortfall together constitutes more than 90% of the aggregate shortfall.
• They no longer have adequate profit margins and equity capital to lend.

• Shying away of Capital Surplus: The top 15 capital- surplus entities are all in the private sector; in spite of that, these firms have raised equity capital or have invested in sovereign bonds.
• Excessive focus on regulatory forbearance:  at the time when the sector is in stress disadvantages of which are:

• It makes book value of capital slow-moving relative to its true economic value, a leading to a low market-to-book ratio.

• Inadequacy of Mergers: While mergers reduce the number of public sector entities, they do not address the issue of the economic size of the sector and associated fiscal risks.

Way Forward: The solution is to enable a graceful transfer of the deposit and funding “franchise” from capital-deficient firms to capital-surplus firms. The government must prepare a significant plan to

• Divest government stakes in public sector banks (PSBs) below majority;
• Improve governance and management practices at PSBs by distancing itself from their operations; 
• Re-privatize some of the healthier PSBs by divesting its stakes fully; and, 
• Prioritize business models of the weaker PSBs by requiring them to specialize in profitable and socially valuable intermediation such as microfinance, 

• Paving way for their improved market valuations and re-privatization in due course.