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Oh Capital, where art thou?

Mar 5, 2012

Capital is necessary for the growth of most businesses, just as oxygen is needed to sustain life. This capital can either come in the way of borrowings (debt) or through equity issuances. In this article we will discuss the banking business and its constant need for capital.

Banking is a highly leveraged sector where assets can be even 20 times the equity base. Mistakes involving only a small portion of equity can wipe out a good portion of capital. Thus Warren Buffett is usually wary of investing in banks. This is unless they have quality operations and don't do dumb things. The sector is highly regulated and has stringent capital requirements. But when the economy is doing badly and capital is scarce, how do banks meet these norms? In this article we will discuss the banking sector's hunt for elusive capital. A situation which a number of public sector banks are facing.

Basel III - A capital guzzler

The Reserve Bank of India (RBI) recently released the draft guidelines for the implementation of the Basel III norms. In this banks' tier 1 (core capital) ratio is required to be 7%. This compares to a 6% standard required globally as per the new guidelines. Total capital including (tier II) is required to be 9% as per global standards. A capital conservation buffer of an additional 2.5% is also needed. This takes the total minimum capital requirement to 11.5%. The kicker is that while the rest of the world has till 2019 to get their act together, Indian banks only have till 2017.

RBI's conservative and timely approach cannot be denied. According to an article in a leading business daily, its conservative approach has a number of advantages. First, it reduces chances of slippages and gives a time buffer for implementation. Secondly, as Indian markets get more sophisticated banks are able to conform to common global practices. Thirdly, new banks which are expected to be announced by the RBI soon can start of on a stronger capital base. Another case is that the government can raise money by diluting some stake in PSU banks. This will help them grow and be more competitive in India's vast banking sector.

Indian banks current capital situation

But on the other hand, Indian banks have always been relatively conservative. They do not trade in risky derivatives or take wild investment bets. They do not have much overseas exposure especially to troubled countries in the Euro region. Their investment banking and other fee income generating businesses are minnows compared to their bread and butter banking businesses.

70% of the Indian banking system is dominated by public sector banks. By virtue of India's primarily agricultural population they are forced to lend to such industries, risking their asset quality. But, as per latest available data Indian banks are relatively secure on the capital front. However, most banks are still far away from meeting Basel III guidelines. And access to capital is essential for the continued growth of the banking system and indirectly the economy.

We have sorted the banks below on the basis of their tier 1 or core capital. This metric is critical for a bank as it consists of all important equity and reserves (including ploughed back profits).

5 worst banks on capital front:
BankTotal CAR (%)Tier-1 (%)Tier-2 (%)
Bank Of Rajasthan Ltd.7.523.763.76
Central Bank Of India11.646.315.33
State Bank Of India11.987.774.21
State Bank Of Bikaner & Jaipur11.687.923.76
Bank Of Maharashtra13.358.025.33
5 best banks on capital front:
BankTotal CAR (%)Tier-1 (%)Tier-2 (%)
Kotak Mahindra Bank Ltd.19.9217.991.93
Federal Bank Ltd.16.7915.631.16
ICICI Bank Ltd.19.5413.176.37
Karur Vysya Bank Ltd.14.4113.071.34
IndusInd Bank Ltd.15.8912.293.60
Source: Ace Equity

In the current edition of the budget, the government made a provision for only Rs 60 bn in the budget to recapitalise its banks. After a long battle, India's largest bank, State Bank of India (SBI) was recently provided Rs 79 bn so that its requirement of tier I capital of 8% could be met. But, where is the money left for the other banks? The government finances are down in the dumps and it barely has money to meet its budgeted expenditures. Fiscal planning is also awry. A few trillion rupees are needed to meet Basel III norms according to some officials. Few extra trillions which the government cannot afford.

Maybe Life Insurance Corporation (LIC) could once again come to the rescue as it has this year for Dena Bank, Bank of Maharashtra, Bank of Baroda etc. A few other banks are also lining up outside the insurer's door for capital infusions. But this again is an unsustainable practice as LIC is already heavily loaded with bank shares.

In conclusion

Well, we don't deny that capital is important for banks to grow, but with the government's finances in a precarious position and GDP growth slowing, infusions from the promoter cannot be the only route. Depending on constant government funding is not be a sustainable practice. And neither is the Center's plan to continue to hold 50% in state-run banks. Incidentally, banks having to shore up their capital for Basel III coincides almost perfectly with the end of India's 12th Five Year Plan. So should scarce capital be used to capitalize banks or should it this money be better used for economic growth?

We believe that banks badly need to focus on the quality of their loan books. After all write-offs and provisioning wipe out a good portion of profits, and hence equity capital. Banks also needs to focus on capital conservation by not lending to risky sectors, route export credit through the Export Credit Guarantee Corp (ECGC) scheme, not have too many subsidiaries etc. Prudent lending and improving profitability of operations is also necessary for banks to become self sufficient. Banks like ICICI Bank and HDFC Bank are relatively self reliant on the capital front because of efficient operations. If current practices continue the hunt for capital will resemble that of a dog chasing its own tail.

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