Why does the government plan to stop capitalizing banks with zero coupon bonds?

You must be aware that zero coupon bonds or deep discount bonds are issued at a discount and redeemed at face value. As a result, there is no intermediate payment of annual or half-yearly interest on such bonds. Instead, the yield is auto-reinvested in such bonds because they are redeemed at a profit. This profit is nothing but the compounded interest on the bond, which is cumulated and paid out at the time of redemption of the bond.

Last year, zero coupon bonds or deep discount bonds were clearly the favourite instrument of the Indian government to recapitalize these banks. That is because, these bonds did not create immediate liability of payment of interest and the government would only have to worry about the same towards the time of redemption which would be typically 10 or 15 years away. This made it more economical in the short term for the government.

However, last year the Reserve Bank of India had raised some objections to the practice of the government recapitalizing the banks with zero coupon of bonds. According to the RBI, such bonds were opaque in two ways. Firstly, these bonds do not capture the annual liability of interest of the government. Secondly, the government presentation of the figure on bank recap contribution would not be a true reflection. Hence the government plans to shift.

The government now plans to revert to using regular coupon bonds to recapitalize the PSU banks. Last year, due to COVID pandemic and the resultant budget constraints, the government relied heavily on ZCBs for bank recapitalization. These special securities had a tenure of 10-15 years and Punjab & Sind Bank was entirely recapitalized by this route.