India's Basel III U-turn: wrong decision, wrong reason
India broke with its traditional instincts last week by scrapping a restriction on retail investors buying Basel III bonds. Not only is the U-turn in attitude towards retail protection startling given the country's past attitude to that investor base, but it could also be reckless.
It is remarkable just how quickly things can change in India. When Basel III standards were first brought into force in India last April, regulators made it very clear that retail investors should not be able to touch these products due to their complex nature and the additional risks that come with them.
Take additional tier one (AT1) instruments, for example. Default on such paper in India can be triggered by a breach of the capital conservation buffer (less than 2.5%), breach of the common equity threshold (less than 5.1%) or if an instituion is deemed to have reached the point of non-viability.
The chances of breaching these thresholds are significantly higher than seeing any default of senior debt. Indian issues of the latter tend to benefit from strong government support — so much so, in fact, that no Indian commercial banks have ever defaulted.
With additional risk comes more coupon, of course, and investors are duly compensated for AT1. That's fine, so long as they truly understand what they are buying into.
Retail accounts, however, don’t share the same level of sophistication as institutional buyers. While they might well gather that these instruments are riskier in some way, the probability of them understanding what exactly is meant by “a hybrid subordinated instrument with equity-like loss-absorption features” could be slim.
It is therefore no surprise that most countries in Asia do not allow retail to buy into Basel III bonds. Thailand and the Philippines are the only exceptions. And even then, there are restrictions on Thai retail accounts, who can only dabble in contingent convertible (CoCo) tier two bonds.
Outside Asia, regulators are also concluding that retail accounts ought not be exposed to these hybrid complexities. The UK’s Financial Conduct Authority last month changed its previous stance and barred retail investors from investing in them for a year, arguing that they were too complicated and risky for the retail market.
That makes India’s decision to do the exact opposite all the more surprising, as surely no one would be tempted to think that Indian retail investors have developed so much over the past 17 months that they now understand Basel III bonds better than the rest of Asia and better than those in the UK.
If improved investor sophistication is not the answer, then the Reserve Bank of India's decision to leave retail investors to their own devices knowing full well that they could get hurt suggests another explanation: its hand was forced.
Domestic ratings agency ICRA recently estimated that India’s AT1 capital requirement for the financial years 2015 to 2019 is around Rp1.9tr-Rp2.1tr ($32bn-$35bn).
That is going to be a mighty tough task. Only two banks have issued AT1 bonds since Basel III was introduced — Yes Bank (Rp2.8bn) last December and State Bank of India (Rp25bn) last month.
That sluggishness is at largely due to a lack of buyside demand. Institutional investors are still coming to terms with the uncertainty surrounding the loss-absorbing features. As things stand, losses can come via conversion into shares or a write-down mechanism, which could be temporary or permanent.
That means the RBI needs to find new funding sources to satisfy Indian lenders’ huge appetite for capital — and fast. Enter the country's retail investors.
The RBI’s way to make sure retail knows what it is buying into is to have investors declare that they have understood those loss-absorbing features. That puts great — and perhaps misplaced — faith in investors' due diligence, and their ability to truly fathom the risks.
What is particularly odd is that the new approach is also out of kilter with India's instincts towards retail investors in other areas. Last year's effort by the Securities and Exchange Board of India (Sebi) to save them from the possibility of a poor IPO with a clumsy safety-net procedure that confused practitioners and was detrimental to issuers was eventually scrapped in the face of opposition. But the attempt was a clear statement of intent.
Giving up on it was clearly the right decision, and a relief given India's historic tendency to regulate heavily. But Basel III securities are patently different, as regulators in much more liberal regimes are demonstrating. If the RBI wants to experiment with liberalisation, complex hybrid securities that make even sophisticated institutional investors blink are probably not the place to start.