Tuesday, September 2, 2014

Dilution of Basel-3 norms offers public sector banks some relief

Dilution of Basel-3 norms offers public banks some relief. The RBI has diluted norms to meet Basel-3 requirements, allowing banks to raise higher debt that qualifies for tier-1 and tier-2 capital. This could come at a lower cost and banks can raise this capital through retail investors, as well. The move is likely to be a big positive for public banks, especially smaller ones, whose ability to access equity markets has been challenging.

Significant relaxation of norms by the RBI to help PSU banks
The RBI has diluted a few guidelines under its revised Basel-3 guidelines. (1) Loss absorption mechanism of AT-1 or AT-2 instruments (Additional Tier) has been revised either as temporary or permanent compared to permanent earlier; (2) core equity, which was the significant driver of the limits of recognizing AT-1 or AT-2 instruments, has been relaxed. Also, banks will be allowed to include a counter-cyclical buffer and capital-conservation buffer during the period of utilization; (3) exercising call options has been relaxed to five years from 10 years earlier; (4) original period of maturity of tier-2 instruments has been relaxed to five years from 10 years earlier; (5) retail investors would be allowed to participate in AT-1 instruments; and (6) banks would be allowed to dip into revenue reserves to pay out interest, subject to certain conditions.  

Besides increasing participation the move may ease pressure to raise capital via equity
We see three major impacts because of this relaxation—(1) the ability to raise debt capital significantly improves as many participants (like insurance companies) were uncomfortable with both the permanent mark-down clause and the duration of these instruments; (2) the cost of raising capital is expected to decline given the relaxations (Bank of India recently raised capital at an expensive 11%); and (3) the quantum of capital raised through equity is expected to decline as debt provides a vital fill-up to meet regulatory capital requirements.

Relaxation of the quality of instruments—positive for PSU banks
We see this guideline as positive for public banks, given their large capital requirements (our estimates indicate US$17-20 bn over the next few years—a quarter of their market cap.). It appears that the relaxation can address a significant headwind for public banks. The impact would be felt two fold—(1) immediate recognition of excess capital for a few banks (see Exhibit 3) and medium impact for banks that would potentially raise capital over the next few years; and (2) risks to RoE and dilution below book has declined as capital requirement is not that large as one would have anticipated earlier.

Ability to raise capital via retail tested in the past, was successful
It appears the move to get retail investors may be a successful one though risks have changed in recent years. In FY2011, SBI successfully demonstrated its ability to raise tier-2 bonds through retail issuance in two tranches. While interest rates may be critical frontline PSU banks like SBI, BoB and PNB may get good retail participation.

All banks will not benefit—leverage ratio unchanged
Medium to small public banks may be challenged by a regulation pertaining to leverage ratio. The RBI has maintained it at 4.5%, which implies that the total leverage is 22.5X. As of FY2014 many public banks (see Exhibit 2) had a fairly high leverage of over 20X, which implies that the recent guideline may help in replacing/recognizing existing instruments but not shift the nature of instruments to debt from equity.

Core tier-1 no longer the key for capital adequacy ratio

Under the earlier guideline of Basel-3, the fulcrum of CAR was around core equity capital against it being a component of total CAR in Basel-2. The illustration below shows that only 27% (1.5%/5.5% or AT-1/common equity) of the core equity tier-1 (reported by the bank) was eligible under tier-1 debt and 36% (2%/5.5% or tier-2/common equity) under tier-2 debt. This would significantly change under the relaxed guidelines. Banks will still have to follow the core equity required, but the relaxation of debt is expected to partially help banks to reach their tier-1 capital and overall capital-adequacy guidelines. It appears we have moved back partially to Basel-2 guidelines.

Leverage levels now act as the constraining factor

While allowing debt addresses a part of the problem, there is another important constraining factor, which is the simple leverage concept under Basel-3. The RBI has not diluted the overall leverage and has maintained it at 4.5% or 22.5X capital. This would imply that banks would not be able to significantly leverage this capital. Several public banks operate at significantly higher leverage (see Exhibit 2) at over 20X leverage, which would imply that these banks would only benefit from recognizing existing excess debt capital as AT-1/2 but the banks would not be able to raise a huge amount of fresh capital in the form of debt. Note that for several banks—IDBI, Indian Bank, PNB and SBI—operating at 13-16X, this guideline is positive as they can rely on these instruments, which are inexpensive compared to raising equity capital.

By M B Mahesh, CFA Institutional Equities Kotak Securities Limited