Europe's bubbling crisis on contingent convertibles, or CoCo bonds, is bad news for Indian banks as poorly rated lenders can well shelve their plans for tapping the international markets to raise capital.
The most preferred CoCo bonds are those through which banks raise their additional Tier-I (AT1) capital. These are bonds that convert to equity when a specified event, such as the stock price of the company falling below a particular level, takes place.
Bonds issued through these instruments have a clause that says if the issuer bank is in financial stress, interest payments for these bonds can be foregone, or at best, curtailed heavily. Since investors in these bonds have to incur a potential haircut, they charge a heavy premium, making these instruments one of the most attractive.
However, that attractiveness is being severely tested now after Deutsche Bank AG's stock prices tumbled about 40 per cent this calendar year, raising uncertainties about the bank's ability to pay the full coupon to investors. Other European banks such as HSBC, Royal Bank of Scotland, Barclays, Llyods Banking Group, Banco Santander and Credit Suisse have seen their share prices fall and thus bonds issued by them are being watched closely.
Indian banks are quite vulnerable in this game. Not only are they restricted by sovereign rating, which is just a notch higher than speculative grade, AT1 bonds themselves are rated at least three notches lower because of their risky nature.
Also, global investors do not see Indian AT1 as investor friendly when compared with Asian peers. "It's very hard for Indian banks to issue AT1s in the dollar market, given the recent widening of European banks' AT1s. Indian banks' AT1 structure has a relatively high trigger for write-downs, so it's relatively risky and requires a much higher spread/yield premium over other Asian banks' AT1s," said William Mak, Nomura's credit analyst in Hong Kong. In the past, some Indian banks tried to raise money through these bonds in the foreign market. But the high coupon sought by investors deterred them. Bank of India eventually raised Rs 2,500 crore from the domestic market at a coupon of 11 per cent, the first to issue such a bond.
Rating agency India Ratings and Research, in its 2015-16 outlook, estimated that Indian banks would need to raise Rs 1.9 lakh crore of AT1 bonds from the market by March 2019. Out of this, banks have raised only about Rs 13,680 crore even as India Ratings estimated an additional Rs 60,000-70,000 crore of capital through AT1 instruments by the end of 2015-16.
Indian banks need to raise capital fast, because the government is tightening its purse strings and bad debts on bank books is also eroding their capital base. The banks' ability to raise capital from the equity market is also limited given the sharp fall in bank stocks. Hence, raising core capital through bonds could have been one of the most viable alternatives. This mode of raising bonds is also highly tax efficient as banks treat the coupon as expense, thus getting a tax rebate of 20 per cent.
However, complicating matters for Indian banks is the Reserve Bank of India's recent asset quality review (AQR) programme. Under the AQR, banks are now throwing up huge bad assets and setting aside massive provisions. As a result, banks have reported heavy losses or depressed profits in the third quarter.
Losses can have ramifications for the domestic market as well as these could trigger non-payment of coupons on some domestically-issued AT1 bonds, say traders.
Naturally, foreign investors would want to stay away from AT1s of Indian banks. However, according to the Indian version of Basel III norms, a bank can still pay its coupon from the past year's reserves. The RBI expects banks to have clean balance sheets by March 2017. Till then, analysts do not expect Indian banks to tap the foreign market for their core capital needs.
Some bankers though, are hopeful that Indian AT1 instruments will be well received in the foreign market because of the implicit sovereign guarantee.
"Indian bonds can be very attractive for yield-chasing investors as, unlike banks in Europe, Indian banks have the backing of the government on capital adequacy," said N S Venkatesh, executive director of IDBI Bank.
According to Venkatesh, Indian banks do not even need to tap the foreign market if insurance companies and provident funds are allowed to buy their AT1 bonds. These firms are now not allowed to invest in anything below AA rated paper. But AT1 instruments, by nature, can have a rating of not more than A in the domestic market. These instruments also cannot be sold to retail investors.
Tapping the foreign market was not cost effective for Indian banks, said Ashwin Parekh, a leading consultant for financial firms. "The ability to raise overseas debt is going to be challenged by the currency risk. At a time when the currency is depreciating, hedging cost nullifies any advantage the bank could receive," said Parekh.