Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Thu, 02 Apr 2020

A preemptive recapitalization of the Indian financial sector

Under normal conditions, we want financial firms to have enough capital to assure their survival. In the aftermath of Covid-19, we would want much more. We would want financial firms that are ready to lend to companies that seek to rebuild their businesses, and to individuals trying to rebuild their lives. We would not want financial firms that bunker down and try to conserve their capital because they are scared about their own survival.

If that is the goal, then India’s financial sector will need a large capital infusion for two reasons:

  1. At least since the ILFS meltdown, the financial sector has been under stress, and many firms, particularly, Non Bank Finance Companies (NBFCs) are vulnerable.

  2. The economic costs of the Covid-19 lockdown (and social distancing) is likely to lead to a rise in both corporate and retail loan defaults. Initial indications from China (which is just coming out of its lockdown) are suggestive of a 5% default rate in credit card loans, and the worst is probably yet to come. A similar phenomenon can be expected in retail loan portfolios worldwide, and India is unlikely to be an exception.

Needless to say, the sovereign is possibly the only source of capital for most NBFCs in the current environment. The government will have to inject capital across the board to NBFCs somewhat like the US did to the banks in 2008 under the TARP (Troubled Asset Relief Program). Indeed the breadth of the capital injection will have to be even broader because the goal is not to ensure that the NBFC survives, but that it has adequate capital to lend freely.

It is also necessary to ensure that this does not become a bailout of the existing shareholders of weak institutions. The broad outlines of such a scheme could be as follows.

The first step would be to determine the amount of capital injection. Starting with the December 2019 balance sheet, the new capital injection could be designed to bring the December 2019 capital adequacy ratio to a level of say 20% of risk weighted assets. This is designed to ensure that even large post Covid-19 loan losses would leave the NBFC with a capital adequacy of say 15% which would be adequate to support a significant expansion of the loan book.

Since an equity valuation is probably impossible under the current conditions, the government’s injection could take the form of redeemable convertible preference shares. The conversion terms would be set such that if conversion happens, the preference shareholder would end up with say 99% of the post conversion capital. In other words, the old shareholders would be diluted out of existence. This would effectively result in the outright nationalization of the NBFC. (Crisis period nationalizations are of course intended to be temporary with the eventual goal of sale, flotation or liquidation.)

But the NBFC could avoid this outcome by redeeming the preference shares two or three years down the line (when the economy and the markets have normalized). A pre-condition for such redemption would be an acceptable post redemption capital adequacy ratio. Hence in most cases, redemption would have to be financed by raising new equity capital at market prices. To incentivize an early redemption, the interest rate on the preference shares could be set at a spread of say 10% (1000 basis points) above the repo rate from the second year onward. The interest rate in the first year could approximate a modest spread over the NBFC’s estimated December 2019 borrowing cost.

The proposed instrument would clearly provide economic capital, but under current regulatory norms, it may not count as Tier 1 capital. If necessary, this gap between regulatory and economic capital could be bridged by regulatory forbearance.

I have focused on NBFCs because that is where the stress is most evident, but it is possible that some weak private sector banks would need the same treatment. The NPA crisis in the Indian banking system and the ILFS disaster have left India’s financial sector too weak to support the credit needs of the Indian economy, and the Covid-19 promises to make things a lot worse. India can ill afford a contraction of credit in these critical times, and decisive action is needed to preserve as much of the financial sector as possible.

Posted at 21:08 on Thu, 02 Apr 2020     View/Post Comments (0)     permanent link