Are Indian banks sufficiently capital equipped?

The '3-6-3 rule' used to be common in banking.

This means that a banker would borrow funds at 3%, lend at 6%, and then be playing golf by 3 PM. The bank would keep the 3% spread (the difference between the borrowing and lending rate), and that would be enough to manage all its expenses, as well as keep a decent profit.

But, things have now changed. The business of banking is not that simple anymore. We are living in an increasingly difficult environment where uncertainty is the name of the game.

The banking industry is central to any economy. And thus regulation of this industry is crucial as well. The RBI has done a commendable job so far in regulating the industry. While global banks, and economies are still recovering from the aftermath of the 'subprime crisis' and 'euro zone' debt crisis, Indian banks have stayed relatively strong. They came off the crisis relatively unscathed. However, the rising interest rate scenario currently may be more of a challenge. Without sufficient capital to grow and meet capital adequacy and provision norms Indian banks may face some issues. Especially, ones which do not have enough equity set aside to absorb the same.

Why is capital so important for banks?

A manufacturing firm like Tata Motors, or a commodity company like Coal India have plants, machinery, reserves etc as their assets. These tangible assets, can be sold in times of distress or to meet their dues. Banks on the other hand, do not own any significant tangible assets. Their assets are mainly loans, and their liabilities are deposits.

Loans will get amortized, and deposits will have to be returned at some point. Since bank's assets and liabilities are just 'paper transactions', these entities need to maintain certain levels of liquid cash and equity capital as a buffer.

PSUs shoring up capital

The 2011-12 Union Budget tabled in the parliament, stated that the government was going to infuse Rs 201.6 bn into the PSU (public sector) banks to maintain their Tier-I capital ratio adequacy ratio (CAR) at 8%. The plan is also to increase the government stake in some of them to 58%. According to the Basel framework, Tier-I capital consists of core capital which mainly includes common stock and reserves (including retained earnings). It may also include non-redeemable non-cumulative preferred stock.

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Bank's assets are weighted by a certain factor according to their credit risk. This is usually determined by the central bank. For example, giving out real estate loans will be much riskier versus investing in sovereign bonds. Accordingly the former will receive a higher risk weighting.

According to the Basel III norms banks need to shore up their CAR and maintain an equity capital at a minimum of 7% of RWA. This includes a common equity capital requirement of 4.5% plus a 2.5% capital conservation buffer. This buffer will help absorb losses during periods of financial or economic stress. All these requirements need to be in place by end 2018.

Indian banks currently have higher Total CAR against the requirement under Basel III of 8%. However, their Tier I ratio, and equity capital base needs to be augmented. The RBI and the government intend to have these in place well before the Basel III deadline.

However a point currently being mooted in parliament is that new capital may be issued with differential voting rights. This may happen in time for the Rs 200 bn SBI rights issue expected next fiscal. This will enable the government remain in the driver's seat. And that too, without significant incremental investment. After all, raising Rs 400 bn from divestment, while having to invest back Rs 100 bn or more back into PSUs, just to keep a controlling stake does not make much sense.

Either way, the fact that the capital base of these banks are set to improve is a comforting factor. This will help them grow and be able to meet any unforeseen situations. As we have established, capital is a key shield that banks can have in place both during good times as well as bad. We are glad that the RBI is showing prudence in having these implemented sooner versus later. But if the new capital is issued with differential voting rights, investors will need to look at the rights issues a little more carefully.