A big bang bailout:

A big bang bailout:

Context:

• India’s banks received a considerable boost with the Union government deciding to inject Rs. 2.11 lakh crore worth of capital into the sector.
• The amount is expected to help put India’s banks on the path to recovery.

What is the utility of the initiative by the government?

• By infusing capital, the government is trying to partially improve the balance sheets of public sector banks.
• This will also help banks write off some of the Rs 10 lakh crore bad loans currently on their books.

What is Bank recapitalization?

• Bank recapitalization means recapitalising banks with new capital to improve their balance sheet.
• The government, using different instruments to add capital into banks which undergoing credit deficiency.
• Since the government is the biggest shareholder in public sector banks, the responsibility of infusing capital majorly lies with the government.

How Bank recapitalization takes place?

• The recapitalisation plan comes into action when banks get caught in a situation where their liabilities are comparatively higher than their assets.
• The liquidity with banks is a liability as it is the money deposited by customers, which needs to be paid sooner or later.
• Due to this their balance-sheet weakens and banks find it difficult to raise capital from the open market.
• Thus, the government, which is also the biggest shareholder, can infuse capital in banks by either buying new shares or by issuing bonds.

Why has Recapitalisation of the Banks Occurred?

• Recapitalisation of the Banks occurs when:
• People defaulted on loans and mortgages;
• banks lent money (bought CDOs) to sub-prime mortgage companies in America who lost money;
• falling house prices means that banks assets decline further and if they repossess homes it’s harder to get value of the original loan back, and
• recession led to more defaults and losses.

Public sector versus private sector banks:

• Mismanagement:  private banks owners, who have invested their own money and stand to lose it all in case of mismanagement, have a strong economic incentive.
• It is a good effort compared to the almost complete negligence and gross mismanagement of books in the case of public sector banks.
• Bad loans: private banks rarely face the problems of bad loans, which is a part and parcel of lending aggressively under a fractional reserve banking system.
• But in the case of public sector banks, the implicit guarantee of their books by the government only adds to it the risk of moral hazard.
• Taxpayer money: as nationalised banks are allowed to tap into taxpayer money whenever they are in deep financial trouble, they have very little reason to be careful while lending and more reason to take huge risks with their balance sheets.
• Incidentally, the same happens whenever the government protects private sector banks from the negative consequences of their actions.

What are the drawbacks of public sector banks in India?

Rise in bad loans:

• The biggest risk to India’s banks is the rise in bad loans.
• These are loans which are not repaid back by the borrower. They are, thus, a loss for the bank.

Inadequate capital:

• One way a bank tries to ensure it is protected from bad loans is by setting aside money as a ‘provision‘.
• This money cannot be used for any other purposes including lending.
• As a result, banks have lower capital available to use for its various operations.

Inadequate technology:

• Public sector banks witness absence of technology.
• There is a need to embrace technology to offer better products.

Failure in credit pattern:

• One major weakness of the nationalised banking system in India is its failure to sustain the desired credit pattern and fill in credit gaps in different sectors.
• Even though there has been a reorientation of bank objectives, the bank staff has remained virtually static and the bank procedures and prac­tices have continued to remain old and outmoded.