Banking Sector Reforms

Recapitalization of state-owned banks: Privatization should do it


From UPSC perspective, the following things are important :

Prelims level: CRAR

Mains level: Paper 3- Recapitalisation of PSBs

The article suggest the approach to deal with the problems banking in India faces.

Banking sector under stress

  • Along with the other sectors, pandemic dealt a severe blow to the banking sector.
  • Stress tests reported in the Financial Stability Report (FSR) indicate that the low ratio of capital to risk-adjusted-assets (CRAR) is likely to decline further.
  • To revive the economy and resume sustained high growth, bold structural reforms will have to be combined with strong fiscal and monetary measures.

Declining credit growth: monetary challenge

  • India’s credit-to-gross domestic product ratio is around 51%.
  • 51% not too low compared to other countries at comparable levels of per capita income.
  • However, the worry is that credit growth is declining rapidly.
  • It is mainly attributable to rising risk aversion among lenders, reflecting the high and rising level of NPAs.
  • Risk aversion spiked during the economic contraction.

Rising NPA of Public Sector Banks

  • The FSR stress tests now indicate that the gross NPA ratio is likely to go up to as much as 13.5% by September 2021 in the report’s baseline case and 14.8% in the ‘severe stress’ case.
  • Within the banking sector, conditions are much worse in public sector banks (PSBs) compared to private banks (PBs) or foreign banks (FBs).
  • The gross NPA figure is forecast to rise to 16.2% for PSBs as compared to 7.9% and 5.4% for PBs and FBs in the baseline case.
  • Clearly, high NPAs are primarily a problem for PSBs, which still account for 60% of India’s total bank credit.

Expanding banking sector: bypass PSBs and give a big push to private banking

  • The recent report on Ownership and Corporate Structure for Indian Private Sector Banks submitted by an RBI internal working group (IWG) espouses this approach.
  • The IWG’s main  recommendation is to enable large corporations and industrial houses to acquire banking licences.
  • The proposal has been strongly opposed by former governors and deputy governors of RBI, several former chief economic advisers, a former finance secretary, and, most significantly, all save one of the many experts the IWG consulted.

Four issues with the push to private banking

  • 1) With an industry CRAR of only 12%, the proposed raising of the promoter share cap to 26% could potentially leverage the promoter’s investment by 32 times.
  • The very high risk appetite generated by such leveraging would subject depositors to a high level of systemic risk, given the limited deposit insurance provided in India.
  • 2) Excessive risk appetite would lead to imprudent lending, especially connected lending to group companies. Conglomerates always find ways around regulatory restrictions against such connected lending.
  • 3) Three, a conglomerate’s bank would have access to insider information on borrower companies that compete with its group companies.
  • 4) Conglomerate banks would lead to massive concentration of economic power and political influence against not just competing companies, but even the regulator.

Way forward

  • A safer and cleaner option would be to help the country’s banking sector grow through simultaneous privatization and recapitalization of PSBs.
  • However, these options do not change the ownership and governance structure of PSBs, which is what primarily is to blame for their poor performance.
  • A better option is for PSBs to recapitalize themselves by raising fresh equity.
  • It would be more prudent financially and also more acceptable politically to test this approach with one or two small PSBs.


Government should try to adopt the approach which reduces the risks associated with giving push to private players in the banking sector while making the PSBs more efficient.

Back2Basics: CRAR-Capital to risk-adjusted-assets

  •  The CRAR is the capital needed for a bank measured in terms of the assets (mostly loans) disbursed by the banks.
  • Higher the assets, higher should be the capital by the bank.
  • A notable feature of CRAR is that it measures capital adequacy in terms of the riskiness of the assets or loans given.

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