Public Sector Banks Recapitalisation: A much needed and timely impetus

Strong common equity tier (CET) 1 was a key reason why Indian banks were shielded from the global financial crisis of 2008.

EY
By EY
Published: 07, Nov 2017

EY is a global leader in its Assurance, Tax, Transaction and Advisory services. It develops leaders who team up to deliver on their promises to all its stakeholders. In doing it plays a critical role in building a better working world for their people, their clients and their communities. EY refers to the global organization and may also denote one or more of the member firms of EY Global Limited, each of which is a separate legal entity. EY Global Limited, a UK company, which is limited by guarantees, does not provide services to clients. Through this blog EY will provide viewpoints, commentary on trends and the delivery of fresh perspectives to evolving issues relevant to executive decision makers. Disclaimer: The information presented on this blog should not be construed as legal, tax, accounting or any other professional advice or service.

People stand in queues at cash counters to deposit and withdraw money inside a bank in Chandigarh, India, November 10, 2016. Ajay Verma/ REUTERS - D1BEULZMQEAA
People stand in queues at cash counters to deposit and withdraw money inside a bank in Chandigarh, India, November 10, 2016. Ajay Verma/ REUTERS

A well-capitalised banking system is needed to ensure a sustained flow of credit in the economy, meet regulatory requirements under the Basel-III norms and provide for stressed assets. Strong common equity tier (CET) 1, was a key reason why Indian banks were shielded from the global financial crisis of 2008. CET1 comprises a bank’s core capital including common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income (AOCI).

Recapitalisation of banks after the global and Asian crises highlighted that credit growth and capital are the two prerequisites for economic revival. However, the Indian banking system, particularly public sector banks, has witnessed systematic capital erosion over the past years amid economic slowdown and worsening of asset quality.

As of March 2017, total stressed assets in the Indian banking system stood at 12 percent of total gross advances. To clean up non-performing assets (NPAs), the Reserve Bank of India (RBI) introduced the Asset Quality Review in 2015 and implemented the Insolvency and Bankruptcy Code 2016. These measures prompted banks to write down their books to realistic levels, resulting in a shortage of capital.

In our view, the total capital requirement of public sector banks is now about Rs 235,000 crore, assuming CET 1 of 8 percent at the end of FY18 and total provision requirements at 40 percent (of current gross NPAs, restructured assets and estimated net slippages in FY18 less the current provisions). They are in desperate need of a capital impetus to resolve this additional capital shortfall and propel credit growth.

Against this backdrop, the Union Cabinet approved Rs 2.11 lakh crore toward bank recapitalisation for state-owned lenders — Rs 1.35 lakh crore through recapitalisation bonds while the remaining Rs 76,000 crore via budgetary allocations and equity issuance possibly through qualified institutional placement (QIP). This move will enable banks to not only revive credit growth to about 18% but also right-size loans. Most of the initial offtake is expected to be Government-led before confidence is restored in the private sector. While the move will not immediately spur credit growth, it will help revive the credit cycle in the medium to long term. It is likely that a lack of urgency for capital at PSU banks may not help to alter their lending policies, limiting the much needed transformation in credit appraisal, monitoring and control. It could also hamper the other critical agenda of privatisation as the need to reduce Government ownership becomes less critical.

The structure of recapitalisation bonds too will play a key role in ensuring the success of the overall package. While the Government is yet to disclose the proposed structure, it could potentially consider the following:

Bonds issued in lieu of equity: These long-term bonds are to be subscribed to by banks to leverage their excess deposits. According to RBI estimates, deposits worth Rs 4.3 lakh crore were accrued to the banking system due to demonetisation. Funds received by the Government through bond issuances could be reinfused in the form of equity to the banks and used for shoring up tier-I capital. This would be on the lines of the recapitalization bonds issued in the 1990s, where they were held till maturity and could be tradable thereafter. This would minimise the impact on bond yields in the short to medium term. Equity infusion should be done under a strict governance framework, including the submission of a turnaround plan and path to profitability by banks, in line with the new accountability outline laid down by the Bank Board Bureau.

However, the key consideration while devising the structure of recapitalisation of bonds will be their impact on fiscal deficit. Under international and IMF standards, recapitalisation bonds do not count toward fiscal deficit as they are considered “below-the-line” financing. However, “below-the-line” recapitalisation bonds should generally be treated as deficit since asset creation out of these bonds may not fetch returns enough to provide liquidity to banks in the event of systematic cash withdrawal. Also, according to the Indian Accounting Standards, these bonds are included in the calculation of fiscal deficit. The Government should ensure that they are actively traded and also placed overseas to reduce deficit after revival in banks’ performances.

At the current long-term interest rate of 6 - 7 percent in government securities, it could add about Rs 8,000 - 9,000 crore to the fiscal burden, affecting India’s chances of a sovereign rating upgrade. Issuing these bonds through a special purpose vehicle (SPV) with implicit government guarantees could allow the government to treat the bonds as off balance sheet items with no impact on fiscal deficit.

Inter-bank recapitalisation bonds:
In this structure, the government could allow issuance of inter-bank additional tier I (AT1) bonds, by banks with greater capital requirements to those with surplus liquidity and minimum additional capital requirement. However, the government may be required to provide support in the form of riders. AT1 bonds are issued in perpetuity and are in the nature of quasi-equity. It will allow banks to raise capital in compliance with Basel III norms. Further, revised RBI guidelines allow banks to use statutory and other reserves to make payments on these bonds in case current year profits and revenue reserves are not sufficient. This will provide weaker banks more flexibility in terms of payment of bonds. Other riders could include allowing these bonds to be treated as SLR (statutory liquidity ratio) category investments.

Besides issuance of recapitalisation bonds, the government aims to infuse additional Rs 58,000 crore through equity issuance in the market (possibly QIP route) and Rs 18,000 crore through budgetary support. However, since infusion through bond recapitalisation will improve credit profiles of the banks and enable them to garner better valuation in the market, equity infusion through the QIP route is advisable only after such bond issuance.

The overall package of PSU bank recapitalisation is expected to kick-start the credit cycle, especially to small and medium enterprises, reviving stalled private investments and creating jobs in the medium to long term. However, the regulators and the government should back this up with a series of structural reforms around governance in banks.

The government should ensure that recapitalisation is aimed at bringing about a change in the mind-set of PSU banks and that it is actively monitored. Absence of which could exert pressure on the exchequer and may result in a credit bubble. While the Union Finance Ministry is yet to come up with the structure and mechanics of the PSU recapitalisation plan, it could certainly turn out to be a tool for transformation of PSU banks.

By Abizer Diwanji, Partner and National Leader - Financial Service, EY

Prev
Bank Recapitalisation: A bankable solution?