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Akash Prakash: Capital cliff ahead

Basel III will stress public sector banks

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are waiting with bated breath to see whether the goes off the “fiscal cliff”. The refers to the automatic and that will kick in by the end of the year unless policy makers in the US can agree to compromise and find a path towards long-term fiscal sustainability. If no compromise is reached, then most market observers expect the US economy to slip back into recession in 2013. The spending cuts and tax hikes could reduce 2013 growth by two or three per cent of gross domestic product.

Although India does not have to deal with a fiscal cliff, it does have an upcoming capital cliff in the banking sector, especially for (PSBs). The Reserve Bank of India (RBI) has decided to go ahead and implement the norms between 2013-14 and 2017-18 and has, in fact, prescribed guidelines that are a little tighter.

As of Bank of America Merrill Lynch has pointed out in a recent note, the Indian banking sector has huge upcoming capital needs. Mr Varma points out that by making some basic assumptions about credit growth (16 or 17 per cent for PSBs), profitability (he actually assumes that PSBs’ profitability rises from here) and the minimum capital ratios banks must get (10 per cent tier I by 2018; regulatory minimum will be 9.5 per cent), one realises that Indian banks have huge upcoming capital needs. His calculations indicate that the Indian banking system will need almost $40 billion of additional capital by 2018. Various other analysts have also come out with similar numbers. Even the has talked of such large numbers in its various reports. Thus, Mr Varma is not an outlier, nor do his calculations or assumptions stretch credulity. In fact one can argue that the numbers will be even larger if we assume that the RBI goes ahead and implements higher provisioning norms for restructured assets and some form of dynamic provisioning.

Of $40 billion, nearly $30 billion will have to be raised by PSBs, which looks to be a tall order. Given that the government insists on maintaining a minimum 51 per cent stake in these banks, the majority of this $30 billion will have to come from the government’s own coffers. The government’s current fiscal position makes it unlikely that it can afford another $15-20 billion capital call obligation (over Rs 1 lakh crore). For a government trying desperately to cut its fiscal deficit to three per cent of GDP, you must really wonder where the money will come from. If the money were to be made available, is this really the best use of scarce resources? There seems to be no political will to cut these banks loose and bring the government’s stake down to below 51 per cent (thus lowering the burden on government finances).

However, even if the banks were told to rely entirely on the financial markets for this money, the difficulties would not diminish. For certain PSBs like IDBI, and UBI, the capital needed for Basel III is greater than their current total market capitalisation! It is obviously very hard for any business entity to raise new chunks of capital greater than your current market capitalisation. For other PSU stalwarts like Punjab National Bank, Oriental Bank of Commerce and Bank of India, the amount of capital needed is equal to about 65 per cent of current market capitalisation. The only two large PSBs for which these ratios seem reasonable are State Bank of India and Bank of Baroda; here the amount needed is large in absolute terms ($10 billion for SBI and $2.5 billion for Bank of Baroda) but is only 35 per cent of market capitalisation for SBI and 40 per cent for Bank of Baroda. Both banks also have investors’ support, and so they will be able to raise the capital needed.

Capital cliff aheadFor private sector banks, the amount of capital needed is about $10 billion, compared to their combined market capitalisation of about $85 billion. So it is not out of the realm of possibility. These banks are also seen as structural market share gainers, with a high return on equity. Thus, investors are happy to provide them with as much capital as needed.

It is true that these capital needs are required till 2017-18 and are, thus, spread out. However, if banks were forced to dilute every year to minimise any single-year burden on government finances, they would risk antagonising investors who don’t want to support continuous and unending annual dilutions.

What is likely to happen, of course, is some type of fudge. The RBI will either delay – or water down – the implementation of Basel III and give everyone more time or lower the capital bar itself. The RBI may also permit some kind of quasi-equity hybrid instruments to be counted as capital, though the wiggle room under the new Basel III guidelines is limited.

Alternatively, if the RBI does not budge, then PSBs (75 per cent of our financial system) will be very constrained in their asset growth. They may find it difficult to achieve more than 12 to 14 per cent asset growth, given the capital constraints they are likely to face. If 75 per cent of the banking system cannot grow very fast, either the country cannot support our desired eight per cent growth or the private banks will have to take up the slack and grow at upwards of 30 per cent (a huge opportunity, given their ability to raise capital). The sector with the biggest impact will be the small- and medium-enterprise space, where PSBs dominate. Private banks have been hesitant to fund these small companies aggressively, and they will find their limited access to capital further constrained as the private banks drive credit growth for the system.

This upcoming capital cliff might also force the much-discussed consolidation among banks. Many banks, with no hope of raising the amount of capital required, will have no option but to merge with larger brethren who can attract the capital they need.

We as a country are going to need huge chunks of equity capital across sectors. We have already discussed the dire state of balance sheets in which the infrastructure players find themselves and their need to de-lever. Now the banks need over Rs 2 lakh crore of equity — and the story is repeated across sectors. India may remain a stock-specific market, with the huge deluge of equity-raising capping broad market returns. It also shows how dependent we remain on foreign capital to fund our growth. If domestic investors continue to stay away from equity products, foreign institutional investors will be the ones buying all this paper. Investment banks in India, at least, still have a future (irrespective of how they fare in the West), for they will be the ones helping raise all this equity!


 

The writer is fund manager and CEO of Amansa Capital

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