Recapitalising Public Sector Banks

Despite finance minister P Chidambaram’s assertions that all our banks are well capitalised and regulated, the only way to grow in the tough times that lie ahead is to provide banks with additional capital

LAST autumn, when finance minister P Chidambaram was visiting USA with his senior officials, he was apparently invited to lunch by treasury secretary Henry “Hank” Paulson. At the meeting, Paulson reportedly held forth on the benefits of an open financial system and the need for India to loosen its controls. Much as this might sound apocryphal, a news wire also recently carried a dispatch from Beijing, detailing how Paulson harangued the audience at Shanghai Futures Exchange 18 months ago about how “an open, competitive and liberalised financial market” was far more efficient than “governmental intervention”.

Cut to the present. The US government’s attempts to staunch the flow of red ink from its financial sector by stitching together a $700-billion bailout plan has brought its role as a champion of open markets, with minimum “government intervention”, into some question. It has also made the US administration the target for a fair bit of ridicule. But, irrespective of whether the package — called the Troubled Assets Relief Programme, or TARP — is right or not, there are broadly three developments in the US that are worth noting.

* Ban on short selling: Governments across the world, irrespective of their ideological shades or origins, try and influence market outcomes through interventionist policies. Sometimes it works, but its toxic after-effects are felt long after the deed is done. The desire to train markets to deliver what, governments erroneously believe, is beneficial to all market participants is dangerous and essentially short term in nature. These follies include stabs at banning short selling in stock markets. The Indian government has attempted this in the past and the US market regulator is among the latest to succumb to this peculiar affliction.
   The Securities and Exchange Commission, followed by regulators in some other countries, has decided to ban short selling in stocks of financial companies, principally to minimise opportunists (read hedge funds) from aggravating the misfortune of defenceless finance companies. However, the move has instead driven out liquidity from the market and, given the shortage of long-only investors, has turned the markets more volatile. Regulators also do not realise that shorts uncover problems long before they are made public and when they’re past any redemption.

* Return to Keynes?: TARP is probably the Fed and treasury’s way of acknowledging that monetary measures can go only a limited distance in solving some of the endemic problems confronting the US banking sector. The Fed has over the past 12 months tried to keep the financial catastrophe at bay by reducing interest rates and by pumping in huge amounts of liquidity. While this did help the banks somewhat initially, it subsequently failed in averting the bankruptcies and the destruction of balance sheets in other financial institutions outside the Fed’s jurisdiction, such as insurance companies and investment banks. Consequently, the fire-fighters cobbled together TARP, probably encouraged and emboldened by the outcome of the past packages put together during the Depression, or the savings and loan bailout.

TARP, in a sense, can be viewed as a surrogate recapitalisation programme for financial institutions and banks that do not have adequate capital to make up for their damaged assets. So far, so good. But two questions arise here. One, what does this do to USA’s burgeoning budget deficit and will it have the desired effect of providing the kind of fiscal stimulus that the administration hopes for? Two, what happens when a host of other personal loan categories — such as credit card, auto and education loans — also goes toxic, as has been feared for some time now? Will that lead to another bailout deal?

* Sea of liquidity: On Monday, just hours before Republicans in the House of Representatives torpedoed TARP, the Fed decided to flood the global financial system with $630 billion in cash — by increasing its existing currency swaps with other central banks in the world (such as European Central Bank, Bank of England and Bank of Japan, among others) by $330 billion and by enhancing its emergency lending programme by $300 billion. This is over and above all the other rehydrating programmes initiated by the Fed in the past.

While TARP does not technically lead to a flood of fresh liquidity into the system, the additional $630 billion is aimed at de-clogging the credit pipelines and reinstating confidence in the system. But it is also like a time-bomb ticking away in the global financial system whose aftermath will be felt much later. Long after the damage is controlled, this cash is likely to stay around and, much like the legacy Alan Greenspan left behind, impact asset prices across the globe. 

All these have enormous implications for the Indian economy. The biggest danger is that Indian policymakers might also be tempted to pursue wrong policies, primarily out of a misplaced sense of having always pursued the right policies and a desire to thumb one’s nose at all the free market votaries. There is a bit of schadenfreude at work here also. India has its unique set of problems and the only way to really unleash the productive energies of the economy is to keep reforming the different markets. Investors are already expressing their disappointment about the five years wasted by this government without implementing crucial reforms in either labour, or agricultural or infrastructure sectors.

Two critical issues arise here. One, the US government’s $700-billion TARP doesn’t automatically give India the licence to be complacent about its ballooning budget deficit, a large part of which is buried under the illiquid oil and fertiliser bonds. Also, India has to quickly move to recapitalise its public sector banks. Despite finance minister P Chidambaram’s assertions that “all our banks are well capitalised and well regulated”, the only way to grow in the tough times that lie ahead is to provide banks with additional capital. As the global, and the Indian, economy slows down, many Indian banks will need to revisit their capital levels. A solution exists — the government has to dilute part of its holdings in these banks. Supply of quality paper can also provide the market with a booster dose in comatose times.

Published as an Op-Ed in The Economic Times (October 3, 2008)