Fitch: First Indian Bank Coupon Skip Shows Capital Pressure

Dhanlaxmi Bank's failure to pay a coupon on a subordinated debt instrument in July 2016 highlights the increased risk to bank capital investors from the mounting asset-quality and capital-adequacy pressures on India's banking sector, says Fitch Ratings.

This is the first time investors in India have had to forgo interest on a bank capital instrument. We view this as a positive development for a system with a high expectation of support for banks and where moral hazard has developed around the assumption that support could be extended to regulatory capital instruments.

The Reserve Bank of India (RBI) can prohibit banks from paying coupons on subordinated debt instruments if capital adequacy ratios fall below the minimum requirements. It raised these to 9.625% in April 2016 from 9%, exposing creditors to risks at banks with tight capital ratios. The RBI is progressively pushing minimum capital requirements higher to meet Basel III capital requirements, and will reach 11.5% by end-March 2019. Systemically important banks will have a higher threshold of an additional 0.2%-0.6%.

Market concerns about bank capital have increased because of the RBI-imposed asset-quality review, which uncovered higher non-performing loans, triggering first-time losses at some banks. This limits banks' ability to generate new capital internally and makes it more difficult for them to access new sources of capital from the market.

We believe Indian banks will need to raise an additional USD90bn of capital by 2019 if they are to meet minimum capital adequacy requirements. As long as potential capital shortfalls persist, creditors will remain exposed to high non-performance risk, which will affect banks' market access to new capital. This is likely to put pressure on the government to inject additional capital into the banks, over and above what it has budgeted so far.

Capital ratios are particularly thin at the state-owned banks, which represent around 75% of sector assets in India.

The RBI appears to be making a distinction between banks that have new capital lined up (which so far have been public-sector banks) in decisions about the performance of regulatory capital instruments. Where capital ratios fell below, or very near to, regulatory minimum requirements, public-sector banks have received capital injections from the government and were able to make coupon payments on regulatory capital instruments.

This was the case in 2014 at United Bank of India, and more recently at UCO Bank and Indian Overseas Bank. But Dhanlaxmi Bank is a privately owned, small regional bank that was unable to attract new capital from its shareholders. State support appears not to be on offer, and therefore creditors are more exposed to non-performance if there are capital pressures.

Sovereign support remains a relevant ratings factor for us, particularly for the large state-owned banks and systemically important private-sector banks.

We think asset-quality indicators are close to their weakest point, but expect bank earnings to remain weak at least for the next 12-18 months. Capital ratios will continue to show signs of strain over the short to medium term, and banks will remain under pressure to raise additional funds. Until they do, risks for creditors will remain high.

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