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Banks: The inevitable 'Tier-III'

Feb 3, 2006

The stalwarts of the North Block are nowadays oft heard reiterating their confidence in the Indian economy and their faith in the economy's potential to achieve 8% GDP growth targets. Understandably therefore, the banking and financial sectors remain one of their priorities when it comes to regulatory licensing and policy framework. In one such development, the central bank recently resolved one of the sector's biggest concerns about capital shortage.Until recently, banks' capital adequacy ratio (CAR) was applicable only to the credit risk assumed by them. Subsequently, capital requirement for market risks for the held-for-trading (HFT) treasury portfolio was introduced during FY05. In addition, banks are required to provide capital for market risk for the available-for-sale (AFS) portfolio by FY06. This would require banks to augment their capital funds to ensure continued compliance with the regulatory minimum CAR. With the transition to the new capital adequacy framework (Basel II) scheduled for March 2007, banks would need to further shore up their capital funds to meet the requirements under the revised framework. Under Basel II, the capital requirements are not only more sensitive to the level of risk but also apply to operational risks.

Banks would thus need to raise additional capital on account of market risk, Basel II requirements, as well as to support the expansion of their balance sheets. As per the erstwhile guidelines, the capital adequacy ratio comprised of only Tier-I and Tier-II capital and banks were not allowed to raise Tier-III capital.

Taking into consideration the above and with a view to provide banks with additional options for raising capital funds, to meet both the increasing business requirements as well as Basel II compliance norms, the RBI has given banks the leeway to raise capital funds by issue of the following additional instruments. Although the central bank has remained shy of giving the innovative capital instruments the nomenclature of 'Tier-III', the instruments complement the previous two tiers:

  • Perpetual debt instruments eligible for inclusion as Tier-I capital

  • Debt capital instruments eligible for inclusion as upper Tier-II capital

  • Perpetual non-cumulative preference shares eligible for inclusion as Tier-I capital, and

  • Redeemable cumulative preference shares eligible for inclusion as Tier-II capital.

If the new instruments find takers, it would help PSU banks, left with little headroom for raising equity, to raise funds without diluting the government's stake in them. Significantly, FII and NRI investment limits in these securities have been fixed at 49%, as against the 20% foreign equity holding allowed in PSU banks.

9mFY06CAR (%)
Corp Bank14.9
HDFC Bank10.3
ICICI Bank14.5
UTI Bank11.6
Banks like OBC and Dena Bank have already exhausted the option of going in for equity issues, as the government holding in these banks has touched the minimum permissible 51%. Others such as HDFC Bank and UTI Bank will also need to soon prop up their CAR to sustain the current levels of asset growth. Also, although the likes of ICICI Bank (post the latest public issue) and Corporation Bank remain well capitalised, they may consider the 'innovative instruments' to support their Tier II funding in the medium term.

Perpetual bonds will have no maturity date, i.e., these will not be redeemable but will pay interest forever. The interest payable to the investors may be either at a fixed rate or at a floating rate referenced to a market-determined rupee interest benchmark rate. However, in its guidelines, the Reserve Bank of India (RBI) has put a caveat that such hybrid securities will cease to provide returns if the issuing bank's CAR falls below regulatory requirements (9%). This makes perpetual debt instruments a risky option for investors, particularly in those banks where the CAR is at lower levels.

What is thus, prima facie palpable is the fact that the 'innovative' instruments hold good only for those banks that have a high credit rating and good asset quality. Else, convincing investors about the security of their capital or garnering the perpetual debts at feasible interest rates will prove to be a complex barrier for banks' capital expansion. The RBI evidently has thus ensured that while deserving banks have sufficient leeway to fund their growth, the inept ones either shape up or ship out!

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