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Banks: Running out of steam? - Views on News from Equitymaster
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  • Nov 18, 2005

    Banks: Running out of steam?

    According to the Finance Minister, public sector banks (PSBs) will need to raise capital to the tune of Rs 600 bn over the next five years to fund their growth, which is estimated to be more than 20% per annum. However, several ones of them that are on close counters with the minimum stipulated 51% government holding limit, seem to be at loss of options to access the requisite funds, leaving them paralysed for growth.

    Capital crunch...
    1HFY06 (%) Government holding Capital adequacy ratio
    OBC 51.1 13.6
    Dena Bank 51.1 11.9
    Vijaya Bank 53.8 12.9
    Bank of India 69.5 11.4
    SBI 59.7 11.3
    Corp Bank 57.2 17.0

    As per the Banking Regulation Act, the government's stake in public sector banks has to be maintained at atleast 51% (SBI being the only exception at 55%) and the Left remains undaunted in allowing the government to amend that law to let banks raise more equity from the market. At the same time, the government itself is unlikely to pump more money into the banks to maintain its stake above the stipulated floor, because of its commitment to fiscal discipline.

    One alternative for PSBs (having 60% of the Indian banking sector's assets) is to slow down and lose market share to foreign and private sector competitors. Another option, which the government and the Reserve Bank of India (RBI) are considering, is to allow PSBs to issue 'innovative' capital instruments. As of now, only equity capital and certain reserves can be reckoned under Tier-I capital. Also, banks are allowed to raise funds by issuing bonds (reckoned as Tier-II capital), but this cannot exceed 50% of Tier-I capital.

    The Indian Banks Association (IBA) has evaluated alternatives exercised by banks in countries such as the US, the UK and Hong Kong to prop up their capital base.

    • IBA has suggested that the RBI could create something called 'Tier-III' capital, which is allowed abroad, and in India, could cover the risk of adverse movements in prices of financial assets.
    • Banks could also set up 'trust-preferred' securities - a special purpose vehicle (SPV), which would raise money from preferred investors. The trust would then lend the raised money to the parent bank.
    • Another option, that of 'irredeemable non-cumulative preference shares', also involves the bank setting up an SPV, which would raise funds in the same way as 'trust-preferred' securities.

    The problem, however, is that the advanced countries have far deeper capital markets than India has, with investors having knowledge of investments in sophisticated financial instruments. In India, a dominant proportion of institutional investment is done by the banks themselves, thus raising the possibility that in the event of materialisation of the above proposals, banks will end up investing in each other's securities.

    While the RBI's approval of conversion of the investment fluctuation reserve (IFR) into Tier-I capital provides considerable headroom to banks to raise additional Tier-II capital, subordinated bonds could also be another feasible option for shoring up the Tier-II base (so as to avoid equity dilution through Tier-I raising). This is because, subordinated bonds are exempted from reserve ratios that are applicable to deposits. On deposits, bankers are expected to maintain a 25% statutory liquidity ratio (SLR) and 5% cash reserve ratio (CRR). Both these mandated reserve ratios yield returns far lower than the term deposit interest rates. They effectively, thus, raise the cost of funds for banks.

    Catch 22 situation...
    PSU banks that are targeting exponential rates of credit growth are thus starved of adequate funds to do so. Inability to grow the capital base will thus not only position them unfavorably with respect to their private sector and foreign counterparts, but also trigger a viscous cycle wherein lower credit growth will enable lower deposit mobilisation and result in contraction of the credit deposit ratio. In the event of rising interest rates, most banks having already offloaded their 'overexposure' to government securities, have also exhausted this contingent liquidity option. The ball, is thus, once again in the 'government's' court! Whether they wish to please their Left allies or cater to the country's financial sector needs will decide the fortune of India's banking heavyweights.



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