RBI to examine buyback of outstanding amount of Rs 84,574 cr in AT-1 bonds

Could disallow retail investments directly and through MFs in the instrument

The Reserve Bank of India (RBI) would examine the buyback of the outstanding amount of Rs 84,574 crore in additional tier-1 (AT-1) bonds issued by banks at par, and a ban on retail investments in them, directly and through mutual funds.
 

These measures include the deletion of the clause which permits banks to service the coupon payable on these AT-1 bonds drawn from their reserves, and the ratings assigned to them. In terms of the current regulatory treatment, these are in the nature of perpetual non-cumulative preference shares (PNCPS), but rating agencies have always treated them as “straight debt”.

“These issues are engaging the highest decision-making levels of the central bank after the blowout at YES Bank, and the write-down of its AT-1 bonds,” said a top official.

The policy framework to be crafted on AT-1 bonds is of considerable urgency given that the coronavirus pamndemic could heighten the pressure to service them. This has serious implications for state-run banks - failure to service these will be akin to a sovereign default. In the past, the banking regulator had asked IDBI Bank to retire its AT-1 bonds. The coupon rate on the outstanding AT-1 bonds ranges between 8.85 per cent and 13.8 per cent.

Exercise of the call option written into these bonds needs the central bank's nod. The call option on AT-1 bonds is contingent on issuing banks replacing it with another such offering or core equity capital (CET-1); and it has capital ratios above regulatory levels - CET-1 of 8 per cent and capital adequacy ratio of 11.5 per cent.

A key aspect of AT-1 bonds as of date is its treatment as run-of-the-mill issuance, which does not capture its “contingent coupon-flow characteristics”. This arises from the fact that the servicing of the coupon is consequent upon banks complying with CET-1, tier-1 and total capital adequacy ratios at all times; and also capital conservation, and counter-cyclical capital buffers etc.

The YES Bank fiasco is “now testing things which were not imagined when the AT-1 bond schematic was adopted from a Basel standpoint”. “It is has implications for small investors, and banks' ability to access alternative capital when equity capital becomes either not viable or available, and the overall bond markets”, said the source.

YES Bank's Rs 8,400-crore AT-1 bonds were written down as it was necessary to do so before the central bank-approved reconstruction plan kicked in.

According to rating agency ICRA, the systemic outstanding by way of AT-1 bonds is currently at Rs 84,574 crore (excluding that of YES Bank). Of this, Rs 53,854 crore is accounted for by state-run banks and Rs 30,620 crore by private banks. The annual run-rate based on the “call options” written into these instruments is Rs 2,670 crore in FY21, Rs 31,920 crore in FY22, Rs 25,355 crore in FY23, and Rs 11,457 crore in FY24.

The key concern is the triggering of the 'no-profit, no coupon' stance, especially in the case of the weaker banks. This not only leads to a severe dislocation in the financial markets with financial stability implications, but erodes capital and the attendant return of profitability. “This is a chicken and egg situation,” said another official.

A bigger concern is that state-run banks may need another round of capitalisation. The Union Budget for FY21 has not made any allocation towards the same.

The idea of AT-1 bonds buyback first came up for discussion within the RBI when 11 banks were under its Prompt Corrective Action (PCA) framework. The AT-1 bonds not only carried a higher coupon, but given the discretion of the RBI to permit payment of coupons even when there was no profit (i.e. not triggering “no profit no coupon” clause), it was felt that AT-1 bonds for all practical purposes are akin to tier-2 bonds but with a higher coupon. “Hence, it may be prudent to retire such expensive funding avenues rather than downgrade them to tier-2 status,” said this second official, who added: “Otherwise, it would have been unfair to the existing tier-2 bondholders.”

Central bank officials felt such a buyback would not be in line with its master circular on the repurchase of these bonds. It was, however, put forth that given the capital constraints faced by banks under PCA, the possibility of deletion of the clause which makes it permissible to service the coupon payable on these instruments from their reserves could be considered.

What has set the stage for a comprehensive relook on AT-1 bonds is the widespread retail exposure through provident funds, mutual funds and the mis-selling of the bonds as fixed deposits with higher coupons. While six state-run banks have been taken out of PCA, the issues surrounding the servicing of AT-1 bonds and the efficacy of such contingently convertible instruments in a market with such shallow investor interest is now an urgent matter which is to be taken up.