"'Benign neglect' of poorly performing state-run banks removes market distortions, which is positive for the stronger and larger public sector banks and private banks," British brokerage Barclays said in the report.

Against a budget allocation of Rs 11,200 crore this  fiscal for recapitalisation of banks, the government had announced only Rs 6,990 crore for nine of the 28 largest and strongest lenders like State Bank of India and Bank of Baroda, among others, the report said.
Indicating that it may follow this fiscal's method of selective infusion during the next fiscal as well, the  Finance Minister allocated only Rs 7,940 crore for recapitalisation of banks for this fiscal, the report said. The criterion for granting capital has been based on profitability.

Barclays said that the outcome from the new capital allocation process is that smaller banks' share of incremental capital is significantly lower than their share in the past, which is a positive change, the report said.

The larger public sector banks, particularly SBI, have stronger deposit franchises than its smaller peers, which have been losing savings deposit market share rapidly despite adding branches as quickly as larger ones.

"Simply put, smaller banks have problems on both the assets and liability sides of the balance sheet. The larger banks are in better shape on the liability side. Thus, providing capital to poorly performing smaller banks merely distorts the market," the report said.
It said the capital allocation process could be further strengthened if it reflected the quality of earnings. "We believe the price-to-book-ratio (P/B) multiple would be a simple way to capture this, which is by penalizing banks that report strong earnings by lower coverage ratios or where earnings reflect risky lending," the report said.
It said allocating capital based on the P/B multiple should also ease the government's fiscal burden as it would imply lower capital contribution for a given level of dilution.
The report said it is important to restrain issuance of additional tier-1 (AT1) bonds by weaker state-run banks. A number of banks that have not been granted equity capital by the government have raised AT 1 bonds.

Out of the total AT1 bonds raised by them in FY15, a majority (Rs 8,100 crore) were raised by banks that have not been granted equity capital by the government, the report said. "This runs counter to the government encouragement of 'efficient banks'," the report said.

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