Banks' deteriorating performance also brings the role of hybrid debt capital in absorbing losses under focus. The market for Basel III Tier 2 instrument is fledging in India and investors will benefit if the Reserve Bank of India (RBI) articulates a framework for invoking losses on the holders of this instrument.
Public sector banks overwhelmingly depend on the government for equity. The government and its wholly owned Life Insurance Corporation of India injected about 95% of equity into these banks between FY10 and FY13. The Prime Minister's Economic Advisory Council, which has an influential impact on policy matters, recently suggested that the government diluted stake in its banks to raise INR550bn for equity injections. Clearly, the government is trying to balance between managing the fiscal deficit, maintain confidence in its banks that control over 70% of system assets and 85% of branches in India and rein in the moral hazard of continuing to support banks that are less efficient.
The situation has deteriorated rapidly for weak banks - quarterly losses in the Central Bank of India and United Bank of India during Q2FY14 were equivalent to about 10% of their equity. Provisions for rising NPLs were the largest contributors to the losses and may remain elevated for the next two quarters, given the weak operating environment and the banks' low loan loss reserves of under 50% of gross NPLs. Equity injections have been announced by the government, but the situation remains fragile. For example, United Bank's net NPL/equity ratio would remain high at 82% even after the injection of the reported INR70bn equity in FY14, while the ratio for Central Bank would be 46% after the injection of INR180bn equity. If rising NPLs push United Bank's ratio above 100%, it will be the first time since 2005 that a bank in India slips above this threshold.
In Ind-Ra's base case scenario, the government's peak annual contribution to banks' equity remains under 1% of GDP under the Basel III regime till March 2018. This is manageable but needs to be planned to avoid any pile-up towards the end. Ind-Ra considers the Basel III guidelines announced by RBI as a credit positive for Indian banks and any dilution in the guidelines may be counterproductive if viewed by the markets as a sign of systemic weakness.
While banks will remain dependent on the government for capital support, the role of the hybrid capital instruments may come under scrutiny. No loss has ever been imposed on the investors of these instruments even in weak private banks, as the regulator has been convinced about the viability of turnaround plans by these banks. Since these instruments provide an additional tool for preserving banks' capital, Ind-Ra believes that a regulatory clarification on invoking losses - for example, defining the framework for identifying the points of non-viability for Tier 2 instruments - will be helpful in developing this market.
Ind-Ra's approach to rating the hybrid debt capital of a bank is to first evaluate the 'stand-alone' credit profile of the bank based on the strength of its balance sheet and future performance. The rating of a hybrid will be anchored around either the Issuer Long-Term Rating or the stand-alone credit profile, depending on whether the instrument absorbs losses on a 'gone-concern' or 'going-concern' basis. Any difference separating the hybrid rating from the anchor will depend upon Ind-Ra's views on the volatility of future performance and the likely need of extraordinary support to maintain the bank's viability.
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