Union government will reportedly hold discussions with RBI in an attempt to persuade it to dilute the capital requirements for Indian banks.
While this is to ease the financial burden on the government with regard to recapitalisation, the move is imprudent.
What is the government seeking to do?
Ratio of common stock and reserves of a bank divided by its risk-weighted assets (expressed in percentage) is called Common Equity Tier - I (CET-I).
Currently, Indian banks are required to hold at least 5.5% of such capital in reserve, which the government is seeking to reduce.
As RBI is the regulator in the financial sector and "CET-I" is its independent prerogative, the government will have persuade the RBI board to this end.
Notably, the international Basel-III standards are less stringent, and require banks to keep only 4.5% in hand.
Why?
Bad loans within banks (particularly PSU banks) have ballooned in recent times – which have increased bank’s “capital adequacy needs”.
Notably, six public banks are close to breaching RBI’s capital adequacy mandate of “5.5% for CET-I and another 2.5% for capital conservation buffer”.
Significantly, Punjab National Bank (PNB), which is the country’s second-largest public sector lender, is also among those 6 banks.
Considering this, the government is staring at the possibility of paying huge sums from its budget to aid failing banks meet their capital needs.
In this context, the government is already under pressure due to its budgetary obligations and is seeking to ease the demands from the banking sector.
Is the move rational?
This would be an imprudent course that is based either on a lack of knowledge of the Indian banking sector or a lack of care.
There is a very good reason why Indian capital adequacy ratios are higher than those recommended by the international Basel-III norms.
This is because the health of the banking sector in India requires greater attention, given the problems of regulation.
Notably, Indian banking is prone to judgemental errors in capital adequacy, misclassification of asset quality, and wrong application of standards.
Such problems are common with developing countries and in fact, many countries have set even higher capital adequacy rations than India.
What is the way ahead?
The basic logic of the Basel-III requirements is for greater capital to be built up at times of growth and is run down at times of weakness.
It is not for the regulations themselves to be altered at precisely the time when they are needed to preserve the health of the banking sector.
The government’s bank recapitalisation plan to secure the health of the Indian banking system cannot be secured by reducing the required cost.
Just because the budgetary package is falling short in terms of size does not mean that other essential regulatory requirements should be diluted.
