India’s banks face a conundrum: they need to find billions of US dollars in a limited time, following a sharp sell-off of their assets.
Their problems stem from Basel III. The international system of bank capital rules will introduce new minimum equity and capital buffer requirements in April 2015, which need to be fully implemented by March 2018.
Reserve Bank of India (RBI) governor Duvvuri Subbarao estimated that these new requirements could require INR5 trillion (US$84.2 billion) in capital, when speaking to the Economic Times on September 4 last year. State banks in particular will need to get more funding.
Subbarao’s estimate is sizeable – roughly 1.4 times the amount India’s banks have raised from the equity and bond markets ove r the past five years, according to Dealogic. And they have just two years in which to find it.
The timing is far from ideal. India’s politicians are focusing on the next general election, coming up by May 2014. No major bank reform or capitalisation is likely beforehand, and a new administration is unlikely to prioritise it just after the election.
It won’t be easy for the banks to find the money from the markets either, given the country’s lack of economic vitality. India’s economic growth dropped to near decade-low levels of 4.7% in the January to March quarter, while the banking sector’s non-performing loan (NPL) ratio rose to a five-year high of 3.6% in the 12 months to September 2012, according to the RBI. Pawan Agrawal, a senior director at international research company CRISIL, thinks it could rise further to 4% by March 2014.
To make matters even worse, investors have begun fleeing emerging-market risk after US Federal Reserve chairman Ben Bernanke discussed ending quantitative easing in 2014. In the six weeks since his June 19 comments, Indian bank shares dropped an average of 30% while their bond spreads widened by up to 100 basis points (bp).
The need for India’s banks to find more capital poses a major headache for an election-obsessed government unwilling to continue writing blank cheques for the banks it owns. Instead, state banks may have to conduct discounted capital issuance or even consider emergency mergers.
The banking sector faces a turbulent time.
Bad loans and Basel III
Look at the capital ratios of India’s banks today and it’s hard to see what the fuss is about. Many local lenders have common equity Tier I ratios close to, or higher than, the minimum 8% of risk-weighted assets demanded by Basel III’s current stipulations.
But the RBI is set to implement new capital rules, encouraged by forthcoming Basel III changes. These will require more capital, 75% of which needs to be injected between the 2016 and 2018 fiscal years. They include raising banks’ minimum common equity requirement from 4.5% to 5.5% of total outstanding risk-weighted assets and a capital conservation buffer of up to 2.5%, according to Ananda Bhoumik, senior director at Fitch Ratings.
India’s banks need INR1.75 trillion in equity capital and INR3.25 trillion in non-equity capital to meet the new requirements by March 31, 2018, a deadline that the RBI set one year ahead of the Basel Committee on Banking Supervision cut-off.
To meet these volumes, India’s lenders would need to issue at least US$5.82 billion in common equity each year for the next five years. That’s more than twice the US$2.5 billion in common equity that the banks raised during the respective 2011 and 2012 financial years, according to Fitch Ratings.
Plus the banks need to sell US$10.8 billion in non-equity, such as subordinated Tier I and Tier II debt, every year over this five-year period – almost double the record US$8.6 billion that they raised in the US-dollar bond markets last year. And almost all of the debt raised in 2012 was senior, not subordinated in nature.
Meeting these increased capital sums will push many banks hard, particularly state-owned institutions. Subbarao told the Indian Express last year that the government’s poor fiscal position will make it hard for it to inject the Basel III capital needs of state-owned banks.
“For some weakly capitalised banks, the capital requirement could go up to two or three times their current market capitalisation,” says Deepali Seth, a Mumbai-based analyst at Standard & Poor’s.
State banks are going to find it tough to finance their own Basel III needs.
“As banks simultaneously tap the capital market, some may struggle to raise the necessary capital,” says Seth.
She estimated in a March 18 report that under an aggressive growth scenario, State Bank of India (SBI) would need INR677 billion in common equity to meet a core equity ratio of 9.5% by March 2018. That is nearly five times the INR140 billion that finance minister Palaniappan Chidambaram has pledged to inject into public-sector banks this fiscal year.
SBI is fortunate to enjoy strong government backing, but that could hurt smaller state lenders with sizeable requirements, such as IDBI Bank. Seth estimates that IDBI needs INR361 billion and Bank of India INR202 billion under the same scenario, and they would have to compete with nearly 30 more state-run banks.
State-bank struggle
Even in good markets, it would be a tall task for India’s banks to raise such levels of capital over five years. And markets are far from good.
Investors holding Indian bank shares will probably see the value of their holdings diluted. CLSA predicts that the lenders’ long-term return on equity will fall about 300bp to 15% if they raise all of the funds needed to increase their Tier I capital ratios to 11%, as Basel III demands.
State banks will find it harder than their private-sector counterparts. SBI, Punjab National Bank and Bank of India, for example, have Tier 1 ratios lingering around 8%. In contrast, the privately owned ICICI Bank’s ratio is about 13%.
Leverage is also a problem for India’s state banks. The new Basel III rules prescribe a minimum leverage ratio, or percentage of Tier I capital to assets including off-balance sheet items, of 4.5%. India’s publicly linked banks have leverage ratios of 4%-5% on average, while ICICI Bank’s is 14% and HDFC’s is 9%.
The state banks’ relatively weak balance sheets are largely due to poor lending practices and weak bankruptcy laws. They have lent heavily to infrastructure projects, which struggle to make money because of stalled policy improvements on coal distribution and tariff increases. State banks are also more prone to maintaining relationships instead of pulling the plug if a client defaults on payments. And India’s laws make it hard to foreclose on defaulting companies.
These problems have continuously weighed on state bank profits and share performance. SBI’s shares fell as much as 8% on May 23 after it reported that fourth-quarter net profit fell because provisions for non-performing assets rose INR10 billion over the previous quarter.
The RBI has tried to prod lenders to control bad loans. It recently revised guidelines on NPL accounting standards, raising the possibility that the banking system’s bad-debt numbers could double to as much as 6.5% by June 2015, according to local ratings agency ICRA. That is likely to place more pressure on banks to raise more capital.
The combination of relatively poor capitalisation, NPL uncertainties and weak share performance meant that state banks were trading at about one times book value for the financial year ended March 2013.
“The share prices of all the state banks are down anywhere from 50%-75% in the past two years because of the worries of dilutions below book value, heavy capital requirements, NPL challenges, and margins coming under pressure. And the consequences haven’t been fully factored in,” says a Mumbai-based equity analyst. “There’s more downside to go. Maybe not as much as we’ve seen in the last two years, but more to go.”
Indian Overseas Bank, Punjab National Bank and Bank of India are believed to be among the most vulnerable to rising NPLs, as they have relatively low capital and high leverage.
For example, India Overseas Bank ranks 36th out of 41 banks when it comes to Tier I capital, according to CLSA, yet it is listed 31st in equity to asset ratios.
Loss-absorbing instruments
Basel III’s new stipulations will also make it even harder for banks to raise subordinated capital.
Under the previous Basel II rules, banks with uncertain NPL levels could still raise subordinated debt, provided they paid for the right. India’s state banks in particular would have appealed because they are mostly government-owned and thus likely to pay bond coupons and return investors’ money.
But under the new capital regime, a bank’s Tier I hybrid instruments must convert into common shares or be written down to zero if its Tier I ratio falls below a certain level. The RBI’s designated trigger point is when the ratio hits 6.125% or less, according to guidelines published in May 2012.
The danger is that the mounting NPLs state banks face could cause them to hit the trigger point, which would leave bond investors holding stock that might not pay a dividend, or with nothing at all.
The new instruments are controversial. Financial regulators in Singapore and the Philippines believe them to be too risky and sophisticated for retail investors.
India’s Ministry of Labour agrees. It has refused to let local provident funds invest in these bonds because of the loss absorption clauses. It’s a crucial decision, because most Indian banks would depend on local fundraising to meet their Basel III capital needs.
“These features significantly increase the risk attributes of Tier I instruments under Basel III, and will negatively impact their acceptability among investors,” says Agrawal.
The RBI is not unheeding of such concerns. It stated in its Basel III guidelines that it would let a bank that hit its trigger reinstate dividend payments under certain conditions. However the lender could only do so at least 12 months after it would have normally paid a dividend, and the value of the reinstated payment can be at most 25% of the dividend paid to common shareholders in a particular year.
Financial institutions group (FIG) bankers applaud the RBI’s efforts to make these bank capital instruments more attractive. But investors are likely to prove very leery about buying into the new structures.
“I don’t see this as a huge factor to get me to buy these even if they can resume it, unless [the dividend] is deferrable but cumulative during that period,” says a Hong Kong-based institutional investor. “If it was a few months ago and they started to issue these types of instruments, then just given the overall hunt for yield issuers could’ve probably gotten away with them. But now it’s very different.”
Another banker laments the fact that state banks may have misleading pricing expectations due to local market experiences. He notes that United Bank of India managed to price a INR5 billion 10-year Tier II bond on June 25 just 50bp higher than its old-style 10-year bonds, which were trading at 8.25%. International investors are unlikely to prove so accommodating.
“The first Indian bank to issue this type of debt to the global markets will probably have to pay a hefty premium of at least 100-200bp,” says an international bond investor.
ICICI Bank, HDFC, Axis Bank and SBI declined to comment.
Under one company
New Delhi is aware of the funding crunch its state banks face. To help ease the pressure the government and the RBI have floated the idea of setting up a financial holding company that raises capital for state-owned lenders.
The idea is that the government’s 51% stake in each state bank is transferred to the holding company. Alternatively, New Delhi would continue holding bank shares but transfer private shareholdings to the holding company.
The government believes it can use the holding company to raise capital and inject it into the state banks. The holding company can also issue bonds to the local and international markets, simplifying the capital injection process and allowing weaker lenders to receive funds without having to pay more than their stronger peers.
But there’s a problem with this idea. The rating agencies consider bonds issued from a holding-company level to be subordinate to bonds issued directly by a bank. That means that such bonds would cost more and be seen as riskier.
“It’s not ideal for bond holders,” according to Dana Kulik Banga, a FIG strategist for Citi. “Asian capital securities have typically been issued by the bank, not the holding company. Basel III securities by bank holding companies would make sense from a capital-efficient perspective, but of course you always want to be close to the financial assets.”
Absolving state banks of the need to raise their own capital would also weaken their motivation to investigate and fix lending weaknesses. It would not force them to become better institutions.
Seeking a solution
The best solution is probably the most painful: the RBI and the government should compel the banks to take control of bad loans. Public-sector banks should be forced to select borrowers based on proper due diligence and not on relationships.
“A public-sector bank, given its DNA, has a handholding attitude, rather than a shedding attitude,” says V. Krishnan, a Mumbai-based equity research analyst at Ambit Capital.
The public-sector banks should hire external experts such as consultants or even private risk managers to help restructure ineffective risk-management systems that cannot weed out bad loans from their books. In addition, the lenders need to monitor the ability for a borrower to repay loans on a more frequent basis.
New Delhi needs to learn lessons too. It likes to lean on its pet banks to lend to systemically important sectors such as agriculture and trading (see box above), and then to not chase the debtors for prompt repayment. Such policy-dictated lending has financial consequences.
“The government is keen to give relief and protect these sectors and their debts. In the short term [that means that] the public-sector banks’ debt position becomes risky,” says C.S. Balasubramaniam of the Babasaheb Gawde Institute of Management Studies, and a former risk management officer at ICICI Bank.
If the government allows its banks to properly assess risk before offering money, they will end up less vulnerable, while the industries they lend to will also have to become more efficient.
India’s banks will ultimately only convince investors to buy the dilutive capital that they need to issue if they can demonstrate concerted efforts to clear up bad debts and improve their lending habits.
“If a banking model has a quality liability franchise reinforced by low cost of deposits, maintain a reasonable cost-to-income ratio and own a disciplined risk profile that allows you to keep a vigil on the quality of assets a sustained period, I would like to invest in such a banking model,” says Chandrashekhar Sambhshivan, investment director at Invesco.
“The deterioration of asset quality is a current problem for state-owned banks and this is getting accentuated with the slow moving government policy machinery. But if it recovers, I think there will be an increased interest coming back to this sector very quickly,” he adds.
Basel III’s strictures are shining a light on shady Indian state bank practices that have existed for too long. The weaknesses of these lenders mean that they are likely to find it a costly and painful process to raise the capital they need.
But the process also offers a rare opportunity for New Delhi to instil fiscal discipline into its institutions. It should seize it.
