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Banks’ Capital Concern

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Basel-III calls for tonnes of capital to fuel state-run banks, but not all of it can come from the Centre given the state of fisc. While a few good ones will be able to tap the bourses, many will not as the valuations are poor. The time for tough decisions is now  

By Raghu Mohan

On 4 October 2011, Moody’s downgraded State Bank of India’s (SBI) credit rating to ‘D+’ from ‘C-’. Its tier-1 capital adequacy ratio had slipped to 7.6 per cent as North Block dithered over an Rs 23,000-crore rights issue to prop it above 9 per cent. Beatrice Woo, vice-president and senior credit officer of Moody’s, justified the action. Her ominous words: “A bank’s ability to freely access the capital markets is an important rating criterion globally. A lower rating is warranted, especially as these circumstances are likely to recur.” It took four months (till February 2012) for the Centre to pump in Rs 7,900 crore through a preferential allotment of shares. And Woo’s words are back to haunt us.

Basel-III capital norms set in from fiscal 2019; it’s to ensure that banks don’t take on excessive debt and play on short-term funds. Born in the crucible of the global financial meltdown of 2008 (and mooted in 2010), it tunnels into capital, leverage, funding and liquidity. It does not replace Basel-I and -II (which stress on the level of loss reserves that banks need to hold), but works alongside. Indian banks will need tonnes of capital.

On 5 June 2013, Reserve Bank of India’s (RBI) then governor, Duvvari Subbarao, estimated additional capital requirement at Rs 5 lakh crore, “of which non-equity capital will be Rs 3.25 lakh crore, while equity capital will be Rs 1.75 lakh crore”. In his first Budget speech of July 2014, Union finance minister Arun Jaitely put it at Rs 2.40 lakh crore. The exact amount depends on a range of factors: credit growth, its quality, dud-loan provisioning, and the technicalities under Basel-III. That’s why Fitch Ratings’ $200 billion (85 per cent to be guzzled by state-run banks) looks out of whack. As Saswata Guha, its director, says: “It’s dynamic. Capital needs will increase progressively from fiscal 2016. CET1 (core equity capital) and AT1 (additional tier-1 capital) are likely to account for close to 90 per cent of requirements; 60 per cent (of the same) will arise between fiscals 2015 and 2018.” You hear whispers that the $100 billion in gross dud-loans is on the lower side; it could be a good 30 per cent more. If true, more capital will be pulled in.

Union minister of state for finance Jayant Sinha sought to allay concerns, and told Businessworld|BW about the comprehensive package to strengthen these banks. “It includes governance reform, strengthening management, operating autonomy free from any political interference, better risk management and technology capabilities; and sufficient capital to meet all regulatory standards and fully support growth of the Indian economy.”

Adds Sinha: “We have undertaken a thorough review of capital requirements for all state-run banks till 2019, and believe that we will be able to provide the necessary support to each to meet all RBI capital adequacy norms.” It is to be given over the next few years in tranches based on regulatory requirements, operating performance and NPA management. “In addition, each state-run bank is exploring a variety of capital raising measures, including equity issuance, disposal of non-core assets and improvements to capital productivity,” says Sinha. It’s a tectonic shift — the first serious attempt to marry capital to productivity. It raises the stakes for the Narendra Modi dispensation in New Delhi.

What’s At Stake Here?
State-run banks account for 76 per cent of our banking assets; given the state of the fisc, it’s anybody’s guess how the Centre will continue to hold 51 per cent in these banks and bring in its share of capital. “They have limited recourse to core equity in the short-term, and have to rely on the government. Declining profitability has hurt internal capital generation; low valuations have virtually precluded access to equity markets and increased their dependence on state support for capital,” adds Guha.

Says Anil Agrawal, head of Research (Banks, ex-Japan) at Morgan Stanley: “State-run banks have trailed private banks and trade at 0.4–1x book. Given the lack of capital at most of these banks, the slide in fundamentals — and hence, the stock prices — could accelerate. He feels the longer the delay, “the tougher it will be to get these banks out of their morass. India needs to aggressively capitalise these banks and restore some semblance of confidence in their balance sheets.”

Jaitely is on record that only the better among state-run banks will get capital; former RBI governor C. Rangarajan tells BW: “If the fisc supports, let capital be given to all of them; if not, some of them.” That’s fair enough. Capital should go to its productive best.

But there will be a vacuum in lending to the extent that many of the weaker state-run banks will “withdraw” — if there is no capital, they can’t lend in the way they did so far. “It (capital) is like fuel in a car’s tank. It will decide how far you will go,” says Romesh Sobti, managing director & CEO of IndusInd Bank. And private and foreign banks can’t step in and fill up the gap. On his part, Rangarajan says: “If state-run banks grow at a slower rate, what’s the issue? When I licensed new private banks in 1993, they had zero share. They will grow as we go along.” It took private banks two decades to notch up a 20 per cent market share; they may ramp up faster, but in the interim, there will be a fallout. You can kiss goodbye to aspirations of an 8 per cent-plus growth in GDP given its link to growth in bank credit; the trade-off in ‘selective capitalisation’ is huge.

There is a link between credit growth and GDP even if it’s not predictable like the Periodic Law. Typically, credit growth is 1.3 times that of GDP growth. “I have assumed 5 per cent inflation (all along) with real GDP rising gradually to reach 9.5 per cent in the terminal year (2019). Based on this, banks will need incremental capital of Rs 5.4 lakh crore-6 lakh crore for four years; the state-run would need Rs 4 lakh crore-4.5 lakh crore or about Rs 1 lakh crore per annum,” says Madan Sabnavis, chief economist at Care Ratings. The cumulative net-profit of these banks in the last two years was around Rs 35,000 crore to Rs 37,000 crore; it gets sucked into reserves. So they will need an additional Rs 60,000 crore through tier-2 bonds or fresh capital. “Even if these assumptions (on GDP) do not hold, and we move at 14 per cent growth in credit for this four-year period, they will need Rs 3 lakh crore-3.3 lakh crore; here too, they will require capitalisation support from the Centre,” adds Sabnavis.

You have another catch: the new GDP data is contested; and if you go by what’s going on at state-run banks that account for the lion’s share of credit, you will find all the more reason to do so. “Systemic loan growth at 9.7 per cent was the lowest over the past decade. The net non-performing assets ratio rose to 4.6 per cent of total assets (4.1 per cent in fiscal 2014), though the bulk of it was accounted for by restructured loans. Consequently, the broader stressed-assets ratio (which includes ‘performing restructured loans’) spiked to 11.1 per cent (from 10 per cent),” explains Guha. Starting fiscal 2016, all such loans will be treated as dud; it will impact capitalisation even as capital buffers have slipped. “Indian banks’ reported tier-1 capital ratio improved to 9.7 per cent (from 9.3 per cent), but the gap between private and state-run banks’ tier-1 ratios widened to 440 basis points,” says Guha. In effect, as state-run banks squirm over capital, private banks will walk away with more business (and investors will hand over the latter more money).

Damned If You Do, Damned If You Don’t
Some give Jaitely credit. “His assertion,” says Pawan Agrawal, chief analytical officer at Crisil Ratings, “is highly nuanced. Nowhere has he said funds will be given to only select banks. What you have is a distinction between ‘growth capital’ for some, and a regulatory requirement for others under Basel-III. That is we will have two ‘categories’ of state-run banks — some will lend and grow; others will mend and grow.” In effect, ‘narrow banking’ —  which is strictly don’t go for mindless growth and mess up again; park your deposits largely in government securities — a thought first articulated by economist S. S. Tarapore as deputy governor of RBI in the mid-90s.   

Agrawal prefers the usage ‘slower banking’, but concedes: “Credit growth is sluggish now, but a year down the line, if and when the economy fires, it remains to be seen who will supply credit.” It can lead to credit rationing as banks opt for safer havens to lend (as capital quotes at a premium) even though some like Vishwavir Ahuja, managing director & CEO of RBL, who breathed the rarefied air of India Inc. as Bank of America’s boss, qualifies: “But then such havens are not there anymore; there are credit concerns across the board.”

“Why do you say all state-run banks should not get capital? You see, 75 per cent of my branches are in the East and north-East. Who is to service this part of the country?” asks P. Srinivasan, managing director & CEO of United Bank of India. North Block’s prescription is seen as tough for the times we live in — it was to take the average of return on assets and return on equity (RoE) of each state-run bank, and based on the above average, banks were to get funds. “Even if all state-run banks were to perform well, many will not get funds as some will be below the average, though it may be higher,” points out Srinivasan. That’s why North Block has gone back to the drawing board to figure out as to how to square the math.

The idea of poorly capitalised banks floating around does not appeal to Mint Road; Anand Sinha, deputy governor, made a reference (12 August 2011) to the ‘valuation aspect’: “There is a line of argument that Basel-III may make raising of capital costlier or difficult for banks due to lower RoE, rendering it unattractive for investors. This, in my view, is not entirely correct because investors will eventually recognise that well-capitalised banks are less risky and hence,will be willing to settle for a lower RoE. Nevertheless, the pressure on RoE should bring about a greater sense of urgency among banks to improve their efficiency by increasing productivity.”

Should fund infusion follow house-keeping? Tarapore is blunt: “If it is a desideratum that all have to be capitalised… Well, there is no divine right that all state-run banks can continue to lend and lose money. Not all are of the same standard, but continue to grow at more or less the same rates.”

And the empirical tells us that recapitalisation in the ’90s saw good money being thrown after bad — the audited books of these banks misled. That’s because the recapitalisation funds were invested by state-run banks in specially issued bonds at a coupon rate of 10 per cent; or what was doled out by the Centre came back to it — it was a book-entry. And these banks showed the ‘interest’ earned as part of their net-profit. Mint Rood ‘netted’ it out to reflect the true state of affairs. Let’s take 1996-97 and 1997-98 (when it was first made public in the Report on Trend and Progress of Banking in India), when 19 state-run banks showed a cumulative net profit of Rs 1,445.12 crore and Rs 2,567.29 crore, but the moment you adjusted it for the ‘interest’ earned on these bonds, the figures read as Rs 609.37 crore and Rs 1,580.66 crore!

When you ask Tarapore if these banks were to vacate the space as a result of the ‘Darwinism’ he advocates: who’s to step in and fuel India Inc? “Physician heal thyself first. You are a sick doctor and you say ‘I want to save my patients’. You first take care of yourself.”

You Can’t Have It Both Ways
A way out of the fund crunch is dilution of the Centre’s stake to under 51 per cent, but bank unions have their own ideas.
Says Vishwas Utagi, vice-president, All India Bank Employees Association: “Basel-III, lack of funds, the selective pick-up of state-run banks (for recapitalisation) is aimed to privatise them eventually. That’s where we are headed. But don’t expect us to just roll over.”

He points to the two-day ‘Gyan Sangam’ held on 2 and 3 January in Pune this year attended by Modi, Jaitley and RBI governor Raghuram Rajan. Jaitely mentioned the intent to bring down the stake to 52 per cent over the next few years; it will fetch Rs 90,000 crore (in the 24 state-run banks with a headroom). The idea of a Bank Investment Company (BIC) was mooted under North Block’s nose to ‘house’ shares of these banks to raise capital, a model in vogue in Singapore and the UK.

Utagi sounds conspiratorial: “They want to set up a BIC, transfer shares into it and sell it (cut stake to under 51 per cent). These banks are also to be brought under the Company Law Board (CLB) soon.” He hopes to forge consensus across the political spectrum against privatisation. “The foundation for much of what the BJP is trying to do was done by P. Chidambaram, like the move to bring banks under the CLB. But in the changed political map, the Congress may align with the Left.”

He takes a dig at Rajan: “He’s bright, but doesn’t understand the Indian context.” Rajan, in a closed-door interaction with bankers at the Centre for Advanced Financial Research and Learning (on 2 February 2015), had said: “An issue generating a lot of interest is state-run banks’ need of capital. I think banks and government ownership in banks can be structured in a way that sufficient capital can be raised without tapping into government coffers.”

The underlying message being not all state-run banks can be part of the race. Says Tarapore: “The RBI has floated the idea of differentiated bank licenses. You specialise in one area or the other. If that’s indeed the way forward, why should weaker state-run banks be all things to all comers?” Srinivasan agrees: “That’s one way of looking at it.” What is unsaid here is you can’t expect state-run banks to do financial inclusion, open millions of accounts under Jan Dhan Yojana, do all kinds of dharma and still, you will not capitalise all of them as you did in the past.

SBI’s chairperson Arundhati Bhattacharya feels differential voting rights (DVRs) will attract strategic investors who do not want management control, but look to reasonably big investments. “It will offer both retail and institutional investors a variation, especially for those who may not be as particular about voting rights, but may see economic value in the form of higher discount offer that may be made; also for incremental dividend and capital gains. It provides a good mechanism for capital augmentation without impinging on the voting rights of the Centre; this is beneficial for both.”

The M. Narasimham Committee-2’s (1998) report on banking reforms was prophetic: “Given the dynamic context in which banks are operating, further capital enhancement would be necessary for the larger Indian banks. Against the background of the need for fiscal consolidation and given the many demands on the budget for investment funds in areas like infrastructure and social services, it cannot be argued that subscription to the equity of state-run banks to meet their enhanced needs for capital should command priority.” It was suggested that the government cut its stake in these banks to 33 per cent. Is it time to revisit the proposal? Says Sabnavis: “We need to understand that if these banks are where they are, it’s because of government’s intervention. Even today, it can’t fill up CMD’s positions. They (the Centre) want to sit on their boards with nominees, but do not want to capitalise them. Then who will?”

From within the establishment, sane voices have been for a reduction in the Centre’s stake in banks. In 2011, Montek Singh Ahluwalia, then deputy chairman of the Planning Commission, reacted to the OECD’s Second India Economic Survey: “These banks with reduced government holding should no longer be governed by social objectives. Employees should have the same status as those in private banks. The corporate governance norms, too, have to be improved so that directors and chief executives are appointed by shareholders, and not the government,” said Ahluwalia.

It’s a very sensitive issue; few want to go on record. BW reached out to Y.V. Reddy, former governor of RBI, on the subject. He says: “We should not continue this conversation.” But in the winter of 2013 (BW 25 February: ‘Reforms should centre on the people of India’), when the question was put to Reddy by this writer: “Given the need to have more inclusive banking and the state of the fisc, how does one account for the capital needed, especially for state-run banks? Is there a case for the Centre to divest stake to under 51 per cent, yet retain the ‘public sector’ nature by way of a Golden share in these banks?” Reddy’s response was: “You are absolutely right. But if you recall, there was a proposal to reduce the stake in state-run banks to 33 per cent. Even when you reduced the Centre’s stake to 51 per cent from 100, governance has been predominantly public sector in nature. So technically, it is possible to reduce stake to 33 per cent and maintain the same character. These are established under special legal enactments, but in principle, you are right. It is like a Golden share, but the jurisdiction of Golden shareholder, namely, government is restricted to material changes in the governance or spheres of activity. Public sector character is more than that of mere Golden share and the former is feasible in India through legal changes even if the government shareholding is reduced.”

Bhattacharya says the concept of a ‘Golden share’ has not yet come. “This may be for two reasons. First, a narrower-legalistic definition of it is needed and second, the Centre has not yet opted for the route for management control. Once state-run banks reach threshold limits of shareholding, the idea may gather some leverage.” However, as per Section-11 of SBI Act, no shareholder (other than the Centre) is entitled to exercise voting rights in respect of any stake held in excess of 10 per cent of the issued capital. Whichever way you look at it, for Jaitely and North Block, it’s trade-off time; the bullet has to be bitten.  

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Wth inputs from Suman Jha

(This story was published in BW | Businessworld Issue Dated 10-08-2015)