Black swan: Govt recapitalisation of banks needs to weigh trade-offs, says RBI paper

Government-provided recapitalisation packages to save banks from a black swan may need to consider trade-offs, including the possibility that firms may benefit from improved discounted lifetime profits but households may be worse off because of lower government expenditure in social sectors, according to a Reserve Bank of India (RBI) working paper.

Government bailout without any deregulation leads to a loss in the household’s utility, whereas profit for firms increases, RBI officials Saurabh Ghosh, Pawan Gopalakrishnan and Abhishek Ranjan said in the paper.

As the government bails out banks, its expenditure on households decreases, they added.

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The aforementioned observation assumes that the government recapitalises either from its budget or by issuing recapitalisation bonds. The former reduces funds available for social spending directly, while the latter reduces it indirectly through interest spending.

Flexible rates

In terms of monetary policy, simulation results indicate that banks’ recapitalisation could be most effective when deposit / lending rates are flexible, as it leads to better rate transmission, according to the paper.

“But an easing cycle coupled with flexible rate regime may lead to a sharp decline in interest income and adversely impact consumers’ income and welfare.

“This also needs policy attention in a society with a large dependency on deposit interest income, emerging financial markets and a lack of social security,” the officials said in the paper titled Saving Banks from a Black Swan: Options and Trade-offs.

Tailored policies

The authors emphasised that it may be important to fine tune demand revival policies (via tax cuts or monetary expansion through an interest easing cycle) with appropriate and calibrated supply-side reform measures to achieve an optimal policy mix.

For instance, in the face of a cyclical decline in interest income, consumers may be encouraged to invest in liquid assets that exhibit counter-cyclical returns (gold bonds).

Further, demand-side measures may also include re-prioritisation of government expenditure towards capex spending and in social sector spending for stimulating demand and welfare.

Finally, on the banking reform side, policies such as further improvements in the banks’ governance and adequate capital buffers may be actively pursued to provide a cushion against black swan shocks and for bringing down the need for future bank recapitalisation, the authors said.

They noted that a black swan event could lead to loan defaults, which may have severe second-round implications for financial and macro stability.

“...The most recent Covid-19 outbreak could be considered an example of such a rare event.

“Well-designed economic policies generally attempt to address frictions (like shrinking liquidity, sticky alternative deposit rates and sticky government yields) and thereby help in economic revival,” the authors said.