Let us understand this with the help of an example:
# We tend to put money into the bank in the form FDs, Savings & Current accounts, etc.
# In order to lend money in the form of loans, banks need to maintain capital adequacy ratio to the tune of around 10%. So if banks want to lend Rs.5000 as loans, it has to maintain Rs.500 as Capital.
# Suppose Bank loses Rs.200 on these loans because of default or making provisions as directed by RBI, in that case Banks capital will get reduced by Rs.200 (loss on account of default or provisioning).
# After the loss has been set off, Banks will have only Rs.300 as capital against outstanding loan book of Rs.4800 (Loans of Rs.5000 – Rs.200 NPA). This comes to around 6.25% as capital.
# In this scenario to maintain the capital adequacy ratio to 10%, banks has to do either of the following:
• Raise Rs.180 as capital to come back to 10% capital adequacy ratio OR
• Call back loans of Rs.1800.
# Calling back loans isn’t possible. So banks stop lending more.
# This is what has happened. Public sector banks have frozen up on lending because they can’t lend more, as their capital ratios will not allow any more.