Fitch: India's Recapitalisation to Prioritise Large State Banks

The first tranche of the Indian government's bank recapitalisation programme, approved by parliament last week, will increase the average core capital ratio of state banks, helping address shortages that weigh on banks' viability ratings and performance, says Fitch Ratings. However, government officials have indicated that capital injections are to be targeted at supporting lending growth, which suggests the heathiest state banks - generally the larger ones - will be the main recipients.

The government is front-loading the capital injections it plans to provide through recapitalisation bonds over the next two years, with the first tranche of INR800 billion (USD12 billion) accounting for 60% of the total. Details are still being finalised, but press reports suggest the government will issue the bonds directly to banks - effectively an accounting adjustment that will not involve any cash transfers. Banks are pushing for recapitalisation bonds to have statutory liquidity ratio (SLR) status, which would boost their tradability and enhance liquidity, but inferences so far suggest that the bonds are likely to have non-SLR status and will be non-tradable.

The government appears set to prioritise lending growth when allocating capital. This is likely to mean that banks currently in the Reserve Bank of India's (RBI) prompt corrective action (PCA) framework will receive no more than the capital necessary to ensure they do not breach minimum regulatory capital requirements. The PCA framework allows the central bank to take a more interventionist approach - often through restricting asset growth. Eleven of India's 21 state banks, including most small- and mid-sized banks, are in PCA.

We therefore expect most of the fresh capital to be provided to large banks that have scope to grow. The injections could allow some of these banks to pursue stronger expansion, particularly if the improvement in their financial profiles helps them independently tap equity capital markets. Punjab National Bank has raised INR50 billion through equity issuance since the recapitalisation plan was announced and other banks, such as Bank of Baroda and Canara Bank, are reportedly looking to follow suit.

Nevertheless, prospects for system-wide credit growth remain weak. A significant proportion of new capital could still eventually go toward absorbing loan losses, even at healthier large banks, given uncertainty over the size of haircuts banks will need to take on bad loans. Meanwhile, banks in PCA are more likely to shrink than expand as the RBI attempts to steer them toward stronger capitalisation.

The recent decision by Indian Overseas Bank (IOB) to set off operational losses against share premium reserves - part of its capital reserves - instead of revenue reserves illustrates the difficulties faced by some undercapitalised banks as they try to avoid skipping coupon payments on loss-absorbing instruments. Fitch estimates that IOB would not have met the pre-requisite of positive distributable reserves for paying its coupon due in February 2018 if it had not dipped into capital reserves.

The move is not unprecedented, but would have required RBI approval. Only two other banks in serious financial distress have been allowed to take this option in the last two decades. IOB may set a precedent for other weak banks to clean up their balance sheets in the same way. The RBI's apparent decision not to block the move also adds to the series of regulatory forbearance that has helped avoid the risk of failed coupon payment in the previous few years. Some small, weaker banks are still likely to fall into the government's consolidation agenda, despite support from fresh capital and regulatory forbearance.

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