Bonds to the Rescue. In a (modi)fied move, Govt. chose to galvanize the sputtered economic engine, not by any ordinary direct stimulus, but by a smart indirect, that too a leveraged one that has the potential to have a dramatic multiplier effect on the economy. Capital bazooka is not just about Rs 2.1tn, but multiple times of that if the lending picks up on the ground as the Govt. hopes. If Govt. had taken the path of any direct stimulus, not only it would have invited criticism from fiscal hawks, its impact would have been mere transitory. Smart thing about this is, it is a stimulus disguised in much needed reform measures for NPA resolution. But the story goes beyond that. On the face of it, this massive recapitalization move comes across like a marvelous engineering where there appears to be no losers, only winners. Or is it just another round-trip trick? Let us look at some of the hard facts to understand this.
First, the Financial Engineering:
How about infusing massive funds into bad-debt laden public sector banks without actually moving any real cash? Apparently, it looks like banks are going to fund their own bail-outs. One may call it a financial jugglery or sophisticated financial engineering. But that is what is at the heart of this bank recapitalization plan. It is a cash neutral plan. But still, it raises capital of the banks in the liability side. Instead of cash, what get stuffed in the asset side are the recap bonds that will be issued by the Govt. or any other intermediary on behalf of the Govt. If they are perpetual bonds (details are being still worked out), what will hit the fiscal numbers will only be the annual interest cost, which is unlikely to be more than 7-8K cr. It is another matter that Govt. can save even that by going in for zero coupon bonds. The new capital that has come into the bank can be used to take the haircuts on the stressed assets and what is left can be used to spur the lending. That is the grand plan. It is interesting to note that Govt. resorted to such recap bonds in the 90s. These bonds were neither tradable nor qualified for SLR (Statutory Liquidity Ratio as mandated by RBI), but later converted into equity or perpetual bonds. This historic perspective is critical to foresee what sort of details is likely to come out in the coming days. It is unlikely that the Govt. will make the recap bonds tradable as they may crowd out private investment.
Cost to the Banks:
In this cash-neutral plan explained above, everyone looks like a winner with no one incurring sizable costs. It will be naïve to assume that such a massive exercise can be done without paying the pertinent dues. To understand the real costs, one has to scratch a little and dig deeper. There appears no free lunch for anyone in the chain. Let us take the case of banks. Cost to the banks come in two forms. First, the erosion in bank’s current bond portfolio because of expected rise in 10 year yields (early signs of which are already visible with ten year G-sec yield moving up by over 10 to 15 bps post the announcement) and second, more importantly, the rise in cost of funding (liabilities) and its impact on profitability (reduction in net interest margin) as markets start demanding higher yield from banks that are stuffed with sizable recap bonds.
Cost to the shareholders:
For shareholders, the biggest risk comes from potential dilution in their holding because of the massive infusion. One should be wary of smaller PSU banks with large stressed assets as the dilution can be as high as 50%+ in the book value, even assuming 20% premium to the current price at which the infusion happens. This would mean the upside potential is low even for banks that are trading at a significant discount to the adjusted book value. Driven by this massive dilution, we expect significant increase in Govt.’s ownership in PSB stack. GOI’s ownership in many of the small and mid-sized banks to shoot up to near 90% as the total capital infusion is estimated to be close to the current market cap for much of these banks (excluding the large banks such as SBI and BOB).
Still, Everyone Can Win:
Strange thing with this bank stimulus is that it can boost confidence which in turn can spur growth that can in turn fuel write-backs in the banking system (reduction of NPA) and so on in a upward spiral fashion. Who knows, like the TARP (Troubled Assets Relief Program) in 2008 in US, this spiral can even lead to Govt. eventually making money from the recap bonds. So much so for the financial engineering and that explains why the field of finance will continue to be fascinating for folks like us for long time to come.
Interesting time to watch out for!