The Reserve Bank of India (RBI) advised on Friday that a mechanism be set up to reward public sector banks with higher asset quality by giving them priority access to capital.
“To avoid the moral hazard problem of government recapitalization of public sector banks (PSBs), an incentive mechanism should be established and banks with better performance in terms of loan recovery and asset quality improvement should be given priority in terms of access to fresh capital,” it said in its report on Currency and Finance (RCF) for 2021-22.
According to the RBI, a lack of market discipline, implicit government guarantees, and recurrent and unconditional recapitalization of public sector banks could create a moral hazard problem. In the last five years, the government has invested 2.9 trillion in PSBs, including 4,600 crore in a recapitalization in 2021-22, helping state-owned lenders increase their capital adequacy to 14.3 percent by December 2021.
The RBI emphasised, however, that capital infusion should not be used as a substitute for improved governance and risk management.
“In the medium term, it is necessary to wean away PSBs from their dependence on government recapitalization; this will be an important pre-condition to achieve greater privatization of the sector,” it said.
The regulator also stated that the RBI’s ‘on-tap’ licencing strategy for universal and small credit banks might be used successfully to boost competition and introduce innovation in the banking sector.
The financial repercussions of the epidemic, according to the RBI, were overlaid on existing vulnerabilities in the industry, limiting the likelihood of finance-led growth. The underlying fundamentals, however, are favourable, and finance-led growth is a realistic alternative, according to the report, but it must be fueled by smart initiatives.
“Banks need to be de-stressed from legacy burden and nudged to direct greater credit towards productive sectors of the economy,” it said.
The regulator also stated that the Insolvency and Bankruptcy Code (IBC) infrastructure needs to be reinforced by expanding the number of National Company Law Tribunal (NCLT) benches and educating more insolvency experts in order to achieve faster and more effective resolution.
“Lenders need to accept haircuts to kick-start the economic recovery process,” it said.
MSMEs can now use the pre-pack insolvency method, which combines the cost-effectiveness of out-of-court settlements with the legal sanctity provided by the IBC framework. On Friday, the RBI stated that this should be extended to larger corporations as well.
The National Asset Reconstruction Company Ltd (NARCL) initiative will require continuous policy backing, expert employees, and operational transparency, according to the RBI. Apart from that, the National Bank for Financing Infrastructure and Development (NaBFID) will have to walk a tightrope between two opposing objectives: profitability and economic development.
