Bank Recapitalisation Bonds for Government-owned Banks

Weak balance sheets of public sector banks warrant infusion of equity capital by the government. Recapitalisation is liquidity neutral for the government when financed via an issue of government securities that a recapitalised bank is mandated to purchase. Bank balance sheets at the time of recognition of non-performing assets and the associated negative net worth is equivalent to that when the bank receives equity through this liquidity neutral mode of financing. Correspondingly, the fiscal deficit is higher than reported the moment a state-owned bank has negative net worth and there are negative feedback loops between the fiscal and banking systems.

Conventional financial wisdom states that to revive an enterprise under financial stress, owners have the option to either infuse more equity themselves or arrange for external fund injections in the form of either debt or equity capital. This infusion of liquidity helps in increasing the loss absorption capacity of the business during the time the management figures out ways and means to address the structural issues affecting the performance. This liquidity infusion in a sick business, however, comes with a trade-off. The fact that the enterprise has non-performing assets (NPAs) makes it difficult to attract external investors, and any infusion from them is likely to have additional costs representing the inherent risks. Inviting external capital dilutes the owner’s stakes in the business. Only if the opportunity cost of the owner’s funds to be injected is higher than the cost associated with external infusion is this dilution desirable from the owner’s perspective. The other option is considering exit if the structural issues persist and restoring profitability remains daunting.