N Jayakumar: The answer to bank capitalisation

The only way for the government to keep control of public-sector banks while also infusing them with funds is through non-voting shares

The 2014 Budget document sets outs a daunting Rs 2.88 lakh crore that public-sector banks need as fresh capital over the next three to four years, in line with Basel-III norms. This regulatory requirement is further underscored by economic growth targets, which need substantial PSU banking support to be achieved. Typically, PSU banks have been the only source of long-term infrastructural finance - as also the inglorious owners of a worsening credit portfolio.

The government has urged banks to depend solely on the capital markets and further constrained the process by underlining its resolve to maintain its equity holding at a minimum of 51 per cent. (Ideas like a bank holding company also necessitate the government to invest further.) Based on current market prices, the universe of listed PSU banks has a market capitalisation of about Rs 4.5 lakh crore, leaving a head-room of Rs 1 lakh crore (approximately) available to be raised through fresh equity issues across the spectrum of banks. One is conservative here in assuming that, first, non-performing asset (NPA) levels don't deteriorate further (which even a peripheral market participant would contest); and, second, a near-unlimited appetite for PSU bank equity exists - at market-driven prices.

Apart from operational efficiencies and a much sharper focus on recoveries, private-sector banks can attribute their richer valuations to a willingness and ability to frequently raise capital, in keeping with business needs. Private-sector banks have typically traded at a multiple to book value; fresh capital issues at market prices have helped in raising book value, which have, in turn, driven stocks up further - this virtuous cycle has been the differentiator (apart from well-documented operational and portfolio issues) between private- and public-sector bank valuations. PSU banks have in fact displayed apathy for their own equity, with the government having chipped in with capital in times of stress and need - facts adequately reflected in most PSU banks trading barely above book value, at a healthy discount to their private-sector counterparts.

The solution for raising capital while maintaining 51 per cent lies in the use of non-voting shares, an instrument that's hardly ever been used in the Indian capital markets. In India, the limited non-voting share issues have taken the form of the DVR (differential voting right) - an instrument which enjoys exactly the same economic value as the ordinary share, has substantially lower voting rights (one-tenth to one-hundredth) and a provision for higher dividend than the common stock equivalent.

Unfortunately, the DVR's trading history has been chequered. The Tata Motor DVR is the most widely traded, while three other smaller stocks which have issued DVRs (Gujarat NRE Coke, Jain Irrigation and Future Retail) are too small and illiquid to be relevant. The Tata Motors DVR was issued at a 10 per cent discount, but investors shunned it; even attempts to increase the free float, through a subsequent offering, could not help to narrow the widening discount, which touched 55 per cent on the high. Over the past year, the DVR has been trading at a discount of between 25 per cent and 50 per cent to its common equity, which still makes it an infeasible parallel for the issuance of such an instrument by others.

But the government could with modifications use the DVR route to fashion its PSU bank capitalisation issue. The solution to the fundamental problem (i.e., the narrowing of the discount) is a two-step process - the thought is to allow only large, index stocks to issue DVRs and to get them simultaneously included in the respective indices (this also ensures that the market cap of fresh stock issued is not "missed out" in index computation). Further, exchange-traded funds (ETFs), which generate market exposures for their investors through purchase of index baskets, will be natural buyers of both the stocks as opposed to just the common equity, as is the case today - the main reason for the irrational pricing discount that exists between the common stock and the DVR.

Incidentally, there exists more than one precedent. Earlier this year, Google, in the US, did a stock split and issued non-voting stock to its shareholders. The stock price halved - had the S&P not included both stocks in the S&P 500 Index, the market capitalisation weight of Google in the index would have dropped by 50 per cent. The S&P 500 nomenclature, they clarified, will henceforth refer to 500 companies (and all lines of stock issued by those index companies). The non-voting counterpart of Google has traded at a discount of between one and two per cent to its common stock, as that has appropriately reflected the economic differential attributed to the lack of a voting right.

Brazil's Bovespa Index has three companies, Vale, Bradesco and Petrobras, all of which have non-voting shares issued and included in the index - these have consistently traded at between an average discount of seven per cent and a premium of one per cent.

Clearly, all PSU banks are a) not part of the index, and b) not large enough to attract investor interest. Hence, consolidation of smaller PSU banks into the index-able large PSUs is the order of the day, a process to be kick-started sometime, hopefully soon. This will ensure that as SBI, PNB, BOB (being prime examples) become larger and better-capitalised, they can absorb smaller PSUs and provide them much-needed capital, while becoming more efficient through rationalisation of expenses/overheads and a renewed assault on NPAs. It's a crying need whose time has long come.

Thus, the government will be able to raise vital capital for its banks, while maintaining control at 51 per cent-plus. Issue of capital could happen at 10-15 per cent discounts to underlying market prices, to give that extra return to investors willing to forgo voting rights.

Further, at some stage, the government could consider relaxing rules for issue of DVRs, by allowing the current cap of 26 per cent of total equity to be increased to 40-50 per cent.

In sum, capital-raising through non-voting shares of index companies and their simultaneous inclusion in the respective indices will be a two-step solution to the PSU bank capitalisation problem.

The writer is the managing director of Prime Securities, an investment banking firm. These views are his own