RBI's 10% Tier-I cap on acquisition financing restrictive, say bankers

Experts suggest 30% equity contribution should include preference shares and convertible instruments

The Reserve Bank of India’s proposal to cap acquisition financing exposure of banks at 10 per cent of their Tier-I capital is restrictive, and the caveat that the acquiring firm has to put in 30 per cent equity towards the deal should also be expanded to include equity and other capital instruments, which could be in the form of preference shares, convertible securities etc said bankers. 

The RBI on October 24, in a draft circular, proposed allowing banks to finance Indian companies’ acquisition of full or controlling stakes in domestic or overseas firms, provided such investments create long-term strategic value rather than serve short-term financial restructuring goals. 

Under the proposal, banks can fund up to 70 per cent of the acquisition cost, with the acquirer contributing the remaining 30 per cent through equity. The acquiring company must be a listed entity with satisfactory net worth and at least three years of profitability. The RBI also proposed capping a bank’s total exposure to such financing at 10 per cent of its Tier-I capital. “The 10 per cent cap (on Tier I capital) is too low,” said a senior executive at a state-owned bank. “The 30 per cent contribution shouldn’t be restricted to pure equity; it should include a combination of equity and other eligible instruments”, he said.  “The RBI could consider raising the limit to around 30 per cent (of Tier I capital) without compromising prudence,” said another senior executive at a state-owned bank. However, experts said that the central bank’s cautious stance is justified given the risks associated with acquisition financing. 

“The acquisition financing norms from the RBI, which we are basically thinking of banks, have a couple of challenges. First, the outcome of every acquisition is not really known. If a credit assessment is based on expected success and the acquisition fails, the bank could face a bad exposure. Banks need to build strong credit underwriting capabilities for this,” said Vivek Iyer, partner and national leader of financial services-risk advisory at Grant Thornton Bharat. 

“Second, acquisition financing is long-term, but banks often use short-term funds, creating an ALM mismatch. If the asset goes bad, it worsens liquidity risk and can affect the loan book. It’s important to raise dedicated funds to prevent this,” he added. He also suggested that while the RBI’s move to formalise acquisition financing is positive, banks should first focus on strengthening their internal frameworks before seeking relaxations. 

Analysts highlighted that there are two key risks associated with acquisition financing, asset–liability mismatch and credit underwriting capability. They noted that banks need to first establish a strong track record by developing a high-quality  acquisition finance book and proving their credibility before seeking any relaxations. According to the analysts, many banks tend to focus immediately on financing large acquisitions, but they should also consider supporting the broader mid-market ecosystem, which would help build market depth and foster sustainable growth. 

“Collectively, RBI’s provisions reflect a progressive attempt to balance market development with credit discipline. They allow Indian banks to participate in strategic value creation while safeguarding depositor interests and financial stability. While the draft is both progressive and comprehensive, certain aspects invite further calibration,” said EY in a note, adding that the scope limitation to listed entities, for instance, could exclude a large cohort of profitable, well-governed unlisted firms — particularly in

India’s mid-market and family business segments, which have driven industrial expansion. 

“The RBI may also, over time, consider adjusting the 10 per cent Tier-1 exposure ceiling for banks with stronger governance, stress-testing, and risk control frameworks”, the note said. 

According to the EY note, India’s M&A volumes have shown remarkable momentum. Excluding private equity transactions, deals worth about $24 billion were announced in H125, with full-year activity likely to cross $ $50 billion. Over the past three years, annual deal values have averaged close to $48–50 billion. By enabling participation in well-structured, risk-mitigated transactions, the RBI’s draft framework could open a new market for banks worth an estimated $10–15 billion annually. Indian banks have been historically restricted from lending for mergers and acquisitions, as such financing can lead to over-leverage, promoter-level funding at the holding company level, and may not directly contribute to asset creation or growth. Having said that, it has been a long-standing demand of the banking sector to allow them to participate in acquisition financing of Indian corporates, especially as corporates are increasingly turning to alternative sources of funds, including the domestic and overseas debt capital markets, and the equity market, for their capex needs, leading to an overall slowdown in credit growth in the system. 

Bankers feel acquisition financing could follow path of infrastructure financing, where a few large banks develop expertise, and smaller banks piggyback on their capabilities, taking smaller exposures.