Offerings of subordinated bonds from the banking sector promise to keep India’s capital markets busy for years. However, the path towards full Basel III compliance is far from straightforward.
The rush to raise new-style bank capital picked up globally in 2014, as more countries began to phase in Basel III capital regulations. In India, the first Basel III-compliant capital instrument was sold within the first three months of the new regulations coming into force, but a promising start has since given way to some tough questions.
India began the transition to Basel III on April 1 2013 and, in June the same year, state-owned United Bank of India printed a Rs5bn (US$81.68m) 10-year Tier 2 bond, the first to come with contractual loss-absorption language, a requirement under the new global standards. UBI’s bonds pay a coupon of 8.75% and were entirely sold to state-owned Life Insurance Corp of India.
There have been some positive developments since, but progress pales against the scale of the challenge.
At the time of writing, Indian banks had sold Rs147bn of Basel III-compliant T2 bonds and just Rs52.8bn of Additional Tier 1 securities. These make little dent in the US$200bn of additional capital that Indian lenders have to raise before the full capital requirements of the Basel rules are enforced in March 2019.
“Raising capital will be challenging for Indian banks, particularly state-owned banks, because of concerns around their asset quality, governance structure and ability to provide sustained value to the shareholders.”
Market participants say lenders, mostly state-owned banks, which form 80% of the Indian banking sector, are most likely to struggle to raise the new capital needed.
According to Fitch Ratings, nearly 41%, or US$82bn of the total US$200bn new capital requirement, will be from common equity T1, while 46%, or US$92bn, will be in the form of AT1 perpetual securities and the remaining US$26bn will be T2 capital.
“Raising capital will be challenging for Indian banks, particularly state-owned banks, because of concerns around their asset quality, governance structure and ability to provide sustained value to the shareholders”, said Naresh Takkar, managing director and CEO of Icra, the local associate of Moody’s.
Equity-market valuations remain low, and only four lenders have sold new shares to the public in the last 12 to 18 months.
High risk, slow beginnings
Basel III rules seek to reduce the need to use taxpayers’ money to bail out troubled lenders. New-style bank capital instruments need to carry loss-absorbing and/or equity conversion features, which make them riskier for investors.
International investors expect a premium for that additional uncertainty and, as a result, price-sensitive Indian lenders have turned to the domestic market.
However, whether or not the rupee markets alone can make up the shortfall remains unclear.
“Today, the PSU banks not only need new capital, about 85% of the total requirement, but, given weak valuations and low earnings, their ability to raise capital is also impacted”, said Saswata Guha , director, Financial Institutions, Fitch Ratings, India.
In the past, Indian banks have relied on heavy equity infusions from the government, rather than subordinated bonds or the public equity capital markets. Given the country’s fiscal deficit, however, the government’s will and ability to continue those injections is set to be sorely tested.
AT1 instruments, which rank only ahead of common equity in the capital structure, are a particular focus for lenders wishing to raise capital without diluting their ordinary shareholders, including, in most cases, the state. Just how risky these securities are, however, remains a matter of intense debate.
Bank of India is one of the three state-owned lenders, alongside IDBI Bank and Indian Overseas Bank, which decided to sell its first Basel III AT1s securities in the domestic market, even after mandating seven banks for an offshore AT1 offering. The bank sold Rs25bn of AT1s with a call after year 10 at 11% in August.
“We highlighted a year ago that there are likely challenges in raising AT1 instruments as these non-equity T1 capital instruments have riskier features”, said Pawan Agrawal, senior director at Crisil.
“Although we have recently seen a beginning in issuance, these are still initial days and we need a track record to understand fully the investor appetite for this capital,” he said.
Gaps and cracks
It is far from plain sailing. At least half a dozen AT1 sales from state-owned banks are stuck in the pipeline.
“There seems to be some disconnect with the risk-return trade off. Even with the latest amendments in place, the AT1s may have become more creditor friendly, but the fact is that these are still loss absorbing and investors will expect additional returns that banks may not be willing to offer,” said Guha of Fitch Ratings.
For instance, Punjab National Bank insists on selling its AT1s at sub-10% levels even as investors see the fair value in the 10.25% to 10.45% range.
Bank of Baroda, another big state-lender, is looking to sell its Rs15bn of AT1s with call options either at the end of year 5 or 10 at 10.05% or 10.10%, although bids for the sale have come in the 10.25% to 10.30% range. Its bonds may get rated AA+, similar to those of PNB.
Canara Bank wants to sell Rs15bn of its AT1s with a call after five-years at a coupon less than 10.25%. The bank also hopes to see its bonds rated AA+.
Not so risky?
Central Bank of India, in which the government holds 88.6% stake, wants to print its AT1 bonds tighter than 10.75%, while investors see fair value in the 11.00% to 11.75% range.
Even though buyers remain reluctant, CBI has a powerful argument on its side.
For FY14, CBI reported a net loss of Rs12.6bn as opposed to a profit of Rs10.1bn a year earlier. Despite the loss, the bank received permission from the RBI to pay coupon on its Rs10bn AA rated Basel III-compliant T2 bonds recently. These 10-year T2 bonds were sold in November 2013 and pay a coupon of 9.90%.
“As CBI did not defer the coupon even after a loss, it has shown that investors are still protected from coupon deferrals risk and, hence, it wants tighter pricing on its AT1s,” said a DCM banker.
In September 2014, the Reserve Bank of India relaxed certain Basel III regulations, incorporating more investor-friendly features, giving confidence to Indian banks that they can achieve tighter pricing on the new bank capital bonds.
“Given the additional risks, banks will have to pay premiums for AT1 instruments. Nevertheless, the cost of raising these instruments is expected to remain cheaper than that of raising equity,” said Crisil’s Agrawal. “Also, the revision in Basel III guidelines in September has helped in partly reducing the risks in AT1. We will watch for investors’ risk premium expectations as the market evolves.”
The RBI allowed temporary write-downs of the AT1s, meaning these instruments after being temporarily written-down can be reinstated once the issuing bank recovers its financial health.
The RBI also allowed coupon payments on AT1s to be made out of revenue reserves even if the issuing bank posted a loss in a financial year. Earlier, the RBI had specified coupon payments on AT1s should be paid only out of the annual profits of banks.
“Investors don’t realise that the government will not be able to bail out every state-owned bank. They should also understand that temporary write-back is a good option to have, but it does not ensure total safety”, said a DCM banker working on AT1 sales.
Takkar of Icra said that, while the RBI had lowered the risk for AT1 instruments, investor appetite for these instruments might still be limited.
“For the core equity requirements, there are concerns over how much the government can capitalise the state-owned banks and to what extent dilution of stake will follow in these banks, particularly when credit demand picks up in the system”, he added.
Although the intent of the RBI might have been different, while relaxing the Basel rules, but the changes had prompted the AT1s to get positioned more as debt instruments than as quasi-equity, said Guha of Fitch.
“In most cases, if a bank comes down to the verge of a temporary write-off, then, quite likely, the next step will be a government capital infusion, which means that some of the loss-absorbing instruments will have to be permanently written down before government capital comes in”, Guha said.
“Therefore, the likelihood of the temporary write-down to be written back is more likely to be an exception than a rule”, he added.
While relaxing the Basel III rules, the RBI also reversed course to allow retail investors to buy locally issued AT1s. This goes against the stance of many European regulators, and analysts believe the RBI has introduced an element of moral hazard in allowing the AT1s to be sold to retail investors as the central bank will be under more pressure to bail out those investors if an issuer runs into trouble.
The point of non-viability, a mandatory trigger in both the AT1 and T2 instruments, also remains a grey area. The PONV trigger is not specified because, as and when it arises, the RBI will decide the point at which a bank should be declared non-viable.
“Basel rules define PONV as a point when the government capital comes in. So, if the government capital comes in before any write-off of the Basel III instruments, is that a PONV?” asked Fitch’s Guha.
Also, analysts said the implicit state-support to banks could not be taken for granted.
“Hypothetically, if the Indian banking system faces a systemic crisis, it will be virtually impossible to provide support irrevocably to all the state-owned lenders. For isolated cases though , the possibility of the government stepping in to bail out (even) the loss-absorbing instruments can be high, but, when the crisis becomes systemic, such bail out possibilities become lower”, said Guha.
Given such risks, Guha doubts the extent to which there will be appetite for the loss-absorbing instruments. “It is highly unlikely that pension and insurance companies would stock up on such instruments just because they are better yielding. At the end of the day, they are potentially loss-absorbing instruments and are expected to behave like equity”, he said.
“Eventually, the real impact will be on the market share of Indian lenders,” said Icra’s Takkar. He believes banks able to raise capital efficiently and are competitive will see their market shares grow. “Consolidation may also emerge. Some weaker banks may get absorbed with better-performing banks,” he said.
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