Changing Face of Indian Banks in 2015-16 : Challenges in Raising Capital to Remain in Business and Retain PS Status
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The developments of last few months are now pointing out towards the changing face of Indian PS Banks in 2015-16 onwards. Most of the bankers are ignorant of these as they are too busy in their day to day working and are usually are not privy to the needs of the bank relating to capital and their impact. Union leaders are too busy in securing their own forts as it is fast crumbling with the arrival of Modi Government and complete wipe out of communists at the central level.
However, this topic being a really important, I thought of sharing with our readers, these facts in a simple language (having worked in Treasury Division and Risk Management Divisions of banks, I have small edge in knowledge about some of the intricacies associated with this topic). I am sure it will help young bankers to get the basics cleared and upgrade their banking knowledge. Seniors too will be able to better appreciate the discussions relating to Basel II and III. This topic can be useful for those who are appearing in interview for promotions in April onwards. It can be useful right from Scale I to Scale VII officers in their forthcoming promotions. I know it is slightly long article, but you will enjoy it if you really wish to upgrade your knowledge about this complex subject.
Why is Capital Needed by Banks ?
Capital is needed in every business. However, in banks capital is of higher importance as banks are in the business of leveraging. A major portion of the bank’s balance sheet consists of Deposits from public, which are required to be returned on demand or on maturity. However, capital is that part of the liabilities of the banks which are not needed to be repaid, and there is no legal liability on the banks to pay dividend or interest on such capital. They may do so if their profits permit these.
Capital is that part of the balance sheet of the banks which is used to absorb shocks during turmoils and may be needed to pay its depositors, customers and other claimants when bank does not have enough liquidity due to losses it suffers from its operations.
Nomenclature used in Banks About Types of Capital :
As per RBI, in India capital of banks is divided into tiers according to the characteristics / qualities of each qualifying instrument. For supervisory purposes capital is split into two categories:
(a) Tier I : It capital consists mainly of share capital and disclosed reserves and it is a bank’s highest quality capital because it is fully available to cover losses.
(b)Tier II capital on the other hand consists of certain reserves and certain types of subordinated debt.
The loss absorption capacity of Tier II capital is lower than that of Tier I capital. When returns of the investors of the capital issues are counter guaranteed by the bank, such investments will not be considered as Tier I / II regulatory capital for the purpose of capital adequacy. Tier 1 is considered the safest. Tier 2 is less safe. A strong capital base is an indicator of a bank’s strength to depositors and investors.
There is also Tier III capital, which at present is not used for regulatory purposes in India.
Elements of Tier I Capital: The elements of Tier I capital include:
i. Paid-up capital (ordinary shares), statutory reserves, and other disclosed free reserves, if any;
ii. Perpetual Non-cumulative Preference Shares (PNCPS) eligible for inclusion as Tier I capital - subject to laws in force from time to time;
iii. Innovative Perpetual Debt Instruments (IPDI) eligible for inclusion as Tier I capital; and
iv. Capital reserves representing surplus arising out of sale proceeds of assets.
Elements of Tier II Capital: The elements of Tier II capital include
(a) undisclosed reserves,
(c) general provisions and loss reserves,
(d)hybrid capital instruments,
(e) subordinated debt and investment reserve account.
International Requirements for capital in banks :
Every country’s banking regulator lays down certain requirements to ensure banks are prudently managed and hold enough capital to ensure that these entities themselves, their customers and other stakeholders are safe and able to withstand any foreseeable problems.
With the increasing inter-dependence of the financial system across the world, it was realized that failure of banking system in one country can have ripples across the world. Thus, an attempt was made to establish a framework of capital requirements across the world. The major international effort to establish rules relating to capital requirements have been laid down in Basel Accords, published by the Basel Committee on Banking Supervision housed at the Bank for International Settlements.
The first set of such a framework as to how banks and depository institutions need to calculate their capital was introduced In 1988 and is popularly known as Basel I. Later on, it was in June 2004 that Basel I framework was replaced by Basel II, which was significantly more complex capital adequacy framework. Inspite of all these regulations, world witnessed the financial crisis of 2007–08, Thus, a need was felt to upgrade even this framework and it was replaced by Basel III which is now under implementation even in India since 2013 and will be gradually fully implemented by 2019
It was as early as April 1992 that Reserve Bank of India decided to introduce a risk asset ratio system for banks (including foreign banks) in India as a capital adequacy measure in line with the Capital Adequacy Norms prescribed by Basel Committee.
What Are Risk Weighted Assets :
We know it well that bank’s primary business is to make money (in the form of interest earnings) from its assets, which primarily are in the form of loans and advances. A part of its assets also consist of investments in government securities, corporate bonds, equity shares, mutual funds etc.
All such assets have some sort of risk of default in interest or / and principal. Loans that are given by a banks to a corporate that has AAA rating will have a lower risk as the chance of default by such corporate will be lower. However, loans and advances given by bank to a corporate with BB rating will carry a much higher risk. Similarly, an investment in government securities will carry almost zero risk, much less than an investment in a BBB rated bonds.
Thus all bank assets do not carry the same risk. Tehrefore, to calculate risk-weighted assets of a bank, first of all we segregate a bank’s loans and investments into separate categories. Each category has a risk weight prescribed by the regulator (in case of India, it is RBI). For less risky loans and investments, this risk-weighted value is low. For more risky assets and investments, this risk-weighted value is high. To arrive at the total risk weighted assets, the amount of loans / investments in each category is then multiplied by its corresponding risk-weights to get the bank’s risk-weighted assets.
What is Capital Requirement / Capital Adequacy Ratio (CAR) :
Capital Adequacy Ratio (CAR) or capital-to-risk-weighted assets ratio is nothing but the ratio of capital a bank has divided by its risk-weighted assets. The capital includes both tier one and tier two capital
Thus, we can say capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. Banks are required to put in place these requirements so as ensure that these institutions do not take on excess leverage and become insolvent. RBI has specifically mentioned that the basic approach of capital adequacy framework is that a bank should have sufficient capital to provide a stable resource to absorb any losses arising from the risks in its business.[ Note : Capital requirements govern the ratio of equity to debt, recorded on the assets side of a firm's balance sheet. It should not be confused with reserve requirements like SLR, CRR, which govern the liabilities side of a bank's balance sheet—in particular, i.e. the proportion of assets it must hold in cash or highly-liquid assets ]
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Government Shareholding Pattern in Public Sector Banks As on 31st March, 2014 -
Out of 27 PSBs, Government of India controls 22 through majority holding. In the remaining 5 banks, state-run SBI holds majority stake. The shareholding pattern in PS Banks as on 31st March, 2014 was as follows:-
Thus, we see that 16 banks have Govt holding in excess of 60%, and thus these banks have a better chance to raise funds from public (without the participation by GoI) and still remain PSUs. On the other hand remaining six banks have only limited scope for raise funds from public and will need support of GoI to continue their status as PSU.
CAR of Indian Banks As on 31st March, 2014 :
Let us now see what is the CAR pattern of public sector banks as on 31st March, 2014 :-
Public-sector banks' average capital adequacy ratio fell to 10.67 per cent as of the quarter ended June,2014 compared with 11.18 per cent in March 2014
Recent Developments On the Front of Capital Infusion in Public Sector Banks :-
GoI has been infusing capital into public sector banks to support their status as PS Banks. The recent developments in this regard upto mid March 2015 can be summed as follows:-
(A) Upto FY 2013-14 : GoI had infused capital of Rs 14,000 crore during 2013-14 in 14 PSBs. [The government has also infused capital of Rs 12000 crore in 2011-12; Rs 12,517 crores in 2012-13];. All these have been accounted for in the above table
(B) FY 2014-15 : GoI has decided to infuse Rs 6,990 crore in 9 PSBs during 2014-15, though Rs 11,200 crore was allocated for capitalization in the interim Budget presented by the previous government in 2014 (However, the budget presented by Mr Jaitley in July 2014, did not mention any specific amount for capital infusion)
(C) FY 2015-16 (Budget) : In Budget for 2015-16. , Finance Minister Arun Jaitley had proposed infusing of only Rs 7,940 crore funds in the public sector banks to enable them maintain adequate capital.
The above pattern of small infusion of capital shows that there is likely to be major shift in the shareholding pattern and CAR of the public sector banks in the years to come, starting the FY 2015-16.
What is Worrisome for PS Banks / Challenges before PS Banks :
(a) The most worrisome factor for the banks is the increasing bad loans, which continue to mount with interest rates still staying high. Gross non-performing assets (NPAs) of public-sector banks increased to 4.1 per cent as of the end of March 2014 from 3.6 per cent a year ago. Their net NPA as a proportion of net advances were 2.2 per cent as at the end of March 2014, as , compared with 1.7 per during the same period a year earlier.
In addition to alarming situation on NPA, Banks are also sitting on a pile of restructured assets, with the ratio of recast assets to gross advances standing at 5.9 per cent as of the end of March, 2014 compared with 5.8 per cent a year ago. Public-sector banks account for 92 per cent of the sector’s total restructured advances.
In terms of RBI guidelines (till mid of March 2015) from 1st April 2015, banks have to make higher provisions for standard restructured advances in line with non-performing asset provisioning which is 15-20 per cent, compared to five per cent now. Thus, with the withdrawal of forbearance of lower provisioning for debt recast from 1st April 2015, banks will need to set aside higher capital for restructuring advances. This will adversely hit the banks. It has to be seen whether RBI comes to rescue of the banks.
With CAR having hit, the weak banks will find it difficult to give fresh credit, and will need additional capital. Thus, there is a danger that some of the banks may not be even able to expand their business which in turn may additionally hit their bottom lines.
(b) Everybody now knows that the public-sector banks will need additional capital in the coming years to comply with the Basel-III norms. According to government estimates, state-run banks would require Rs 2.4 lakh crore of equity capital by 2018 to meet Basel III norms, which are now being implemented in phases in India from April 1, 2013, and these will be fully implemented by March 2019. Banks are expected to remain under pressure on the capital front due to additional requirements towards the capital conservation buffer, the counter-cyclical capital buffer and supervisory capital, apart from supporting business growth.
Thus, it is another major challenge for banks as to how to raise capital. With merely Rs7940 crores budgeted for 2015-16, the outlook looks dimmer for the PS Banks.
We have mentioned above that government has announced infusion of Rs 6990 crores in nine banks in January 2015. It was during the Gyan Sangam meet, which was attended by PM Narendra Modi, held on 1-2 January 2015 and attended by the chairpersons and managing directors of PSBs and financial institutions, where it was stated that Banks which are more efficient would only be rewarded with extra capital for their equity so that they can further strengthen their position.
To infuse capital on efficiency parameters, weighted average of return on assets (ROA) for all PSBs for last three years was put together and all PSBs, which were above the average, were considered for capital infusion. The second parameter that was considered was return on equity (ROE) for these banks during the last financial year, and similarly those performing better than average have been rewarded. So far, the Union government was infusing capital to those banks hit by equity erosion. The details of the capital infused in 2014-15 (announced till mid March 2015) are as follows:
This selective infusion of capital surprised the remaining 12 banks. Banks that have not received capital, which is essential for growth and provisioning for stressed assets, are in a quandary. Government shareholding in 12 banks that were denied fresh capital in 2014-15, ranges between 65 per cent and 80 per cent. Thus, these banks are wildered as to how to continue with the growth and raising of capital.
It has also sent undercurrent signals that either you perform or perish.
(c ) There are two more developments which needs to be kept in mind :-
(i) The government has shown that PS Banks should go to the market and raise capital tapping the retail investor base, keeping the minimum government holding at 52 percent. However, tapping market as wanted by would not be an easy task for most of the PS banks, which have their valuations and balance sheets under pressure.
(ii) On 11th March, 2015, the government has allowed seven public sector banks (PSBs) to tap markets for raising capital needed for expansion and capital adequacy, saying it has limited fiscal space to recapitalise lenders. However, the government has not yet disclosed the names of banks which have got government approval for raising capital through market, not did it give quantum and timing of such public issues.
Thus, now the government made its stand clear when in mid March 2015, Financial Services Secretary Hasmukh Adhia told reporters that "The government doesn't have space to give Rs 20,000 crore or 25,000 crore (for capital infusion) ... If banks require further capital they have other means to raise capital including from raising capital from market.".
Thus at the time of writing this article (ie mid March 2015), it is clear that GoI will not be supporting the weak banks as it was doing in the past. They will need to raise their capital requirement funds on their own, even if it results in dilution of Government holding in such banks. However, the Government has shown inclination to dilute Government stake only upto 52%. Thus, soon will find some banks may be forced to tap the market inspite of not being good times for banking stocks at the stock market. If they fail to tap the market, their CAR will go down and thus now allowing them to further expand their business, thereby bring their growth to halt.
Thus 2015-16, will see changes in the pattern of Government holding in PS Banks and some weak banks may face the dilemma of either stopping their growth activities or merge with stronger bankers. Thus, Government may be able to implement its agenda of bank mergers without any legislation or notifications.
These are the testing times for banking industry as they have failed to take timely action, and encouraged corruption in promotions, in last one decade when their NPAs were increasing and their CMDs were giving false hopes at the end of each quarter that next quarter will see improvements, whereas they continued to slip further deep into red as far as NPA level is concerned. Now, it is time to perform or perish for weak banks.