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2006-February-Newcapitalinstruments

2006-February-Newcapitalinstruments

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ICRA Rating Feature

February 2006

Introduction of new capital instruments: Indian banks get greater latitude to raise capital

Contacts:
Vineet Gupta vineet@icraindia.com +91-22-2433 1046/53/62 Vibha Batra vibha@icraindia.com +91-11-23357940-50

On the face of it there has been no significant change in the reported capital adequacy (capital as a percentage of risk-weighted assets) of Indian scheduled commercial banks (SCBs) since March 31, 20031. However, if one were to look at the underlying risk-weighted assets and capital, these have undergone significant changes post-March 31, 2003. While the risk-weighted assets of SCBs have grown by almost 55% during the period stated, a similar increase in capital has allowed them to maintain stability on the capital adequacy front. Going forward, given the significant credit growth and regulatory changes expected, the Indian banking system’s appetite for capital is likely to increase over the medium term, when the avenues of the past for capital-base expansion may show up as inadequate. Anticipating this likely scenario, the Reserve Bank of India (RBI) has, in line with the Basel II guidelines and international experience, introduced certain regulatory changes in 2005-06 so as to provide greater latitude to Indian SCBs to reinforce their capital base. This paper tries to look at how the Indian banking system has fared on the capital adequacy front in the past and at the ways available to them to expand their capital base, going forward.

Website: www.icraratings.com www.icra.in
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Their Capital Adequacy Ratio has moved up marginally from 12.7% as on March 31, 2003 to 12.8% as on March 31, 2005

the following fiscal (2004-05) saw a marked increase of around 40% year-on-year (yoy) in their risk-weighted assets. although the impact of this regulation may not be very significant for the system as a whole. various regulatory changes brought in by the RBI resulted in the risk-weighted assets of SCBs increasing by a higher 40% (yoy) for advances vis-à-vis 28% for their advances portfolio.00% 12. Despite this however. the increase in their Tier 2 capital was facilitated by a rise of 30% in subordinated debt and of 15% in their Investment Fluctuation Reserve (IFR). Further. the RBI’s guidelines on Capital Treatment for securitisation deals are likely to add further to the requirement of additional capital.00% 3. in 2004-05. the requirement of market risk allocation for the “held for trading” portfolio is also likely to have contributed towards the increase in the risk-weighted assets of SCBs in 2004-05. The major regulatory changes that increased the RWAs on the credit side included: increase in risk weight for consumer loans from 100% to 125%. which matched pace with the growth in risk weighted assets. While the regulatory changes 2 3 as the capital allocation would be based on credit risk profile Page 2 on the “available-for-sale” portfolio from 2005-06 onwards 4 from 2006-07 onwards ICRA Rating Services . 2004-05”. This was the outcome of a substantial expansion in capital base (especially Tier 1 capital). Thereafter.00% 6. but regulatory capital adequacy remains stable While SCBs reported moderate growth in their riskweighted assets and capital in 2003-04. the banking system was able to maintain a capital to risk weighted assets ratio (CRAR) that was almost similar to that reported in the previous year.00% Mar-03 Mar-04 Mar-05 Table 1: Increase in risk-weighted assets of Indian Scheduled Commercial Banks vis-à-vis capital April 2003– April 2004– March 2004 March 2005 % Increase in Capital Tier 1 10% 39% Tier 2 31% 22% Total Capital 17% 32% % increase in Risk-weighted Assets (RWA) RWA: Credit 17% 39% RWA: Others 11% 22% Total RWA 15% 34% Source of base data: “Report on Trend and Progress of Banking in India. RBI In 2004-05. Moreover. The road ahead With the adoption of Basel II guidelines. growth in the risk-weighted assets of SCBs is likely to be quite pronounced in the coming two years on account of the regulatory changes. following a similar trajectory as the rate of business growth. According to ICRA. the pace is likely to drop to moderate levels. While internal capital generation and equity issues helped SCBs grow their Tier 1 capital in 2004-05. This however is likely to be more than offset by the requirement of additional allocation for market risk3 and operational risk4. which together are expected to add significantly to the risk-weighted assets of Indian SCBs over the medium term.ICRA Rating Feature Introduction of new capital instruments by RBI Risk-weighted assets increase significantly. given the relatively small size of the domestic securitisation market. Movement in Capital Adequacy of Indian SCBs Chart 1 15. the rate of increase of risk-weighted assets on the credit side is broadly estimated to be marginally lower than the pace of credit growth as some capital gets released following the implementation of the standardised approach2.00% 9. increase in risk weight for home loans from 50% to 75%. and increase in risk weight for loans to Public Financial Institutions from 20% to 100% for credit risk.

160 billion through equity and around Rs.00% Mar.65%7 on account of old Tier 1 and around 3. In the current financial year (2005-06). the utilization was only close to 16% for the other component (Tier 1 minus Subordinated debt) as the components eligible under this were limited. the rush of scheduled commercial SCBs to reinforce their capital base. ICRA has taken Net Tier 1 as the base for computations as there is lack of clarity on this issue. Although the increase in credit provisions for standard assets would increase utilisation of this part marginally. gross of any deductions (barring goodwill).65%).Mar03 04 05 06 07 08 09 10 Tier 2 capital Tier 1 capital New capital instruments: increasing the options to raise capital Till recently. 2007.5% on account of the IFR inclusion in Tier 1) and effect a corresponding increase in the scope for enhancing Tier 2 as well. Put together. SCBs significantly. especially for public sector banks5 (PSBs) and even for the rapidly-growing private banks.5% by March 31. the sum would be adequate to cover 20% growth without dilution in capital adequacy. Ergo. However. i. Innovative Tier 1 can be raised up to (15%/85% = 17. 20066: This will increase Tier 1 capital by around 20% over the March 31.00% 0.00% 9.00% 6. Market risk and operational risk are expected to contribute to increasing the risk-weighted assets by 15-20% over the March 31. would also have to reinforce their capital base Considering the current buoyancy in the business environment and the strong growth in retail credit. Now. if one were to assume no change in capital vis-à-vis the March 31. innovative perpetual debt should not exceed 15% of Tier 1. according to the RBI circular of January 2006 Year. 2005 levels during the same period. the only options available to Indian SCBs to shore up their capital were equity issues and subordinated debt.Mar. This could have been a limiting factor. ICRA Rating Services Page 3 7 . it is estimated that SCBs would be raising Rs. According to ICRA’s estimates. the high growth expected in the riskweighted assets of SCBs could lead to a significant reduction in capital adequacy if SCBs were to rely merely on internal capital generation.Mar. However.65%) of Old Tier 1. risk-weighted assets of SCBs could grow by 70-85% over the next two years. 2005 IFR was part of Tier 2 According to Basel II norms. 180 billion through subordinated debt issues. if Gross Tier 1 were to be taken as the base.00% 3. Expected Movement in Capital adequacy of Indian SCBs ( assuming no external capital augmentation of estimated Capital beyond March 31. Thus. Inclusion of IFR in Tier 1 from March 31.Mar. The recent regulatory changes provide more flexibility to SCBs to achieve superior Tier 1.Mar. apart from internal generation. the ceiling would be higher at 20% of old Tier 1 (compared with 17. 2005 levels and provide greater latitude for the raising of Tier 2 capital. the new instrument would allow SCBs to close this gap.Mar.e. Despite this however. over the medium to long term. On the whole.Mar. the scope to raise capital via equity issue is limited by the fact that Government’s holding in the PSBs is already close to 51% 6 till March 31. ICRA expects growth in SCBs ’ credit related risk-weighted assets to be in the range of 55-65% over the next two years. 5 for them. while SCBs utilised headroom for subordinated debt to the extent of around 48%. besides offering significantly greater latitude for the raising of Tier 2 capital. 2006. Introduction of Innovative Perpetual Debt Instrument: This would increase the leeway for Tier 1 by 21% (17. So far. the capital adequacy of scheduled commercial SCBs could fall below the regulatory 9% by March 2009 in the absence of external capital support. overall credit offtake for SCBs is likely to remain strong over the medium term. 2006) Chart 2 15.ICRA Rating Feature Introduction of new capital instruments by RBI discussed would lead to capital better reflecting risk. 2005 levels. The expectation is corroborated by the over 30% yoy growth in SCBs ’ non-food credit till end-January. Introduction of Senior Subordinated debt: This would lead a significant increase in the ability of SCBs to increase Tier 2 since the subordinated debt component is now restricted to 50% of the total Tier 1 capital while the overall Tier 2 component can go up to 100% of Tier 1. the capital adequacy of SCBs would drop sharply to 7-7. before getting aligned to the business growth rate subsequently.00% 12.

240 150 1.089 March 31. with the Upper Tier 2 increasing the 8 excluding equity issuances Page 4 ICRA Rating Services .654 Increase in leeway over original March 31.ICRA Rating Feature Introduction of new capital instruments by RBI The combined impact of these regulatory changes has been computed in Table 2.659 352 1.65% of A Total Tier 2 Tier 1 + Tier 2 Leeway for Innovative Tier 1 570 1.240 150 1.089 1. Table 2: Capital markets and regulatory changes in 2005-06 increase the latitude available to SCBs to augment capital Basis of Computation of Latitude for Capital Raising As on March 31. However. the leeway available to them would have been adequate to support just about 17% growth in their risk-weighted assets without any change in capital adequacy.659 553 2. equity issues and major regulatory changes during 2005-06 have given SCBs significant space for raising external capital. 2004-05”. 2005 (actual) Tier 1 Gross Tier 1 Less Deductions Net Tier 1 IFR Total Tier 1 Tier 2 B1 B2 Tier 2 Bonds IFR 263 217 263 Reduce leeway by the extent of the other Tier 2 compone nt (-B3) 50% of C 50% of C 443 Reduce leeway by the amount already raised (-B1) 1.184 Source of base data: “Report on Trend and Progress of Banking in India.415 1. the extent by which SCBs may increase their capital is brought out in Table 3.65% of A 50% of A 50% of A March 31. 2005 levels 403% 488% Mar-05 Extant regulations Mar-05 Regulatory changes introduced in 2005-06 Mar-06 Infusion of capital + regulatory changes 231 288 679 850 As Table 3 shows. Given the guidelines then.089 217 1. Table 3: Increase in leeway to raise capital Total Leeway As on As per the 8 Innovative Tier 1 Upper Tier Subordinated Total Leeway 2 Bonds ( Old Tier 2) 282 506 517 282 1. 2006 (estimated) Innovative Tier 1 Upper Tier 2 Subordinated Bonds (Old Tier 2) A1 A2 A= A1+A2 B3 Other Tier 2 90 90 110 B A+B C =17.631 17. SCBs had limited options to boost capital till March 2005.307 1. Using the base numbers worked out in Table 2. 2005 (with IFR as part of Tier 1) 1. RBI Please refer Annexure for a comparison on the features of the new instruments mentioned in Table 2.

the cross-holdings11 among banks could have the result of increasing the capital levels of individual banks even as the capital level of the banking system as a whole remains static. capital adequacy pressures The new instruments. Noticeably.50% 12. Moreover. this would contradict the spirit of the Basel Accord. banks appear to be the largest potential investors. Success of new instruments hinges on investor diversity. it is these very features that would force issuers to pay a premium over normal subordinated debt. which combine the features of debt (regular interest payments. This in turn could result in the market remaining thin for the new instruments. while the premium may act as some sort of a deterrent. As of now. Table 4: Permissible increase in risk-weighted assets over the estimated March 31.00% 11. Thus.00% 6% 18% 32% 52% Scenario 2 Innovative Tier 1 + Subordinated bonds 18% 30% 45% 68% Scenario 3 Innovative Tier 1 + Subordinated bonds + Upper Tier 2 53% 67% 78% 78% As is evident from Table 4. However. while the equity-like characteristics of the new instruments make them eligible for inclusion in capital. prompting individual banks to opt for the new instruments.80%10 12. around 17% of the leeway available to the SCBs now is in form of superior Tier 1 Capital. scheduled commercial banks may first seek to exhaust the existing options for capital raising (which may work out cheaper) and only then go in for the new instruments. for instance) and equity-like characteristics (such as long/perpetual maturities and provision to defer payments) are yet to be tested in the Indian market. 9 10 11 subject to the condition that Tier 1 does not go below 6% Capital Adequacy of scheduled commercial banks in India as on March 31. 2005 restricted to 10% of the total capital of a bank Page 5 ICRA Rating Services . the pressure on capital adequacy may prove to be the overriding factor. The increase in capital would help SCBs achieve a sharp increase in their risk-weighted assets at different capital adequacy levels. at least in the short term. the banking system as a whole can augment its capital base using the new instruments to absorb the significant likely growth in risk-weighted assets while maintaining capital adequacy well above the regulatory minimum. 2006 level9 At Capital Level Adequacy Scenario 1 Only Subordinated Debt 13. as brought out in Table 4. developing a diverse investor base for these long-maturity instruments would be no small challenge. Further. Clearly. but if they prove to be so.ICRA Rating Feature Introduction of new capital instruments by RBI latitude considerably.

Call option only after 10 years. subject to RBI approval Not liable to pay either interest or principal if CRAR falls/likely to fall below minimum regulatory requirement. subject to a ceiling of 10% of total capital Investment by FIIs & NRIs. Banks can hold the instrument. subject to a ceiling of 10% of total capital Attracts CRR/SLR reserve 100% Not Allowed Attracts CRR/SLR reserve 100% Not Allowed Page 6 . 20 Subordinated Bonds (Old Tier 2) Tier 2 capital Not required (requirement only for foreign banks) 50% of Tier 1 Subordinate to claims of other creditors Minimum 5 years No option allowed Seniority of Claims Maturity Put/Call option Debt Servicing No such restriction Rate of interest G SEC (of similar maturity) + 200 basis points Not available Rate of discount (%) 100 80 60 40 20 Step up option Remaining maturity < 1 yr. rest can be included in Tier 2 up to the ceiling Superior to claims of investors in equity shares Perpetual No put option. subject to RBI approval Non-cumulative interest. subject to RBI approval in a loss situation Market determined rupee interest benchmark rate Up to 100 basis points from initial rate. Market determined rupee interest benchmark rate Up to 100 basis points from initial rate. allowed once during life of instrument to be used in conjunction with the call option Upper Tier 2 Upper Tier 2 capital Required only in case of foreign currency issuance 100% of Tier 1 along with other components Superior to claims of investors in equity shares and investors in instruments eligible for Tier 1 Minimum 15 years No put option. subject to RBI approval in a loss situation. debt servicing possible. Call option only after 10 years. subject to 49% & 24% limit respectively. but can be paid.ICRA Rating Feature Introduction of new capital instruments by RBI Annexure Comparison amongst the features of various debt instruments Innovative Tier 1 Nature of Capital Prior Approval from RBI Limit Tier 1 capital Required only in case of foreign currency issuance 15% of Tier 1. Interest can be accumulated and Interest and principal can be paid once the conditions are met. subject to 49% & 24% limit respectively. allowed once during life of instrument to be used in conjunction with the call option Rate of Remaining discount maturity (%) < 1 yr. 100 > 1 yr but < 2 yrs 80 > 2 yrs but < 3 yrs 60 > 3 yrs but < 4 yrs 40 > 4 yrs but < 5 yrs. with individual ceilings of 10% & 5% respectively. Banks can hold the instrument. need not be paid if CRAR falls/likely to fall below minimum regulatory requirement. subject to a ceiling of 10% of total capital Attracts Cash Reserve Ratio (CRR) / Statutory Liquidity Reserve (SLR) 100% Not Allowed As per existing FII investment limit Banks can hold the instrument. with individual ceilings of 10% & 5% respectively. However. > 1yr but < 2 yrs > 2 yrs but < 3 yrs > 3 yrs but < 4 yrs > 4 yrs but < 5 yrs Discount None Investors Reserve Required Risk Weight (Investor Bank) Grant of advances against the security of instrument ICRA Rating Services Investment by Foreign Institutional Investors (FIIs) & Non-Resident Indians (NRIs).

makes no representation or warranty.icra. www.icraratings. as to the accuracy. Website: www.com. ICRA Limited. 2006.ICRA Rating Feature Introduction of new capital instruments by RBI ICRA Limited An Associate of Moody’s Investors Service CORPORATE & REGISTERED OFFICE Kailash Building. such information is provided ‘as is’ without any warranty of any kind. 2280 0008. 4th Floor.: + (91 22) 24331046/53/62/74/86/87. All Rights Reserved.in Branches: Mumbai: Tel. ICRA Rating Services Page 7 . Fax + (91 44) 2434 3663 ❏ Kolkata: Tel + (91 33) 2287 0450. 2335 5293 Email: info@icraratings. 2240 6617/8839. Contents may be used freely with due acknowledgement to ICRA. and ICRA in particular. Fax: +(91 11) 2335 7014.: +(91 11) 2335 7940-50. Fax: + (91 22) 2433 1390 ❏ Chennai: Tel + (91 44) 2434 0043/9659/8080. Fax + (91 40) 2373 5152 ❏ Pune: Tel + (91 20) 2552 0194/95/96.com. All information contained herein must be construed solely as statements of opinion and ICRA shall not be liable for any losses incurred by users from any use of this publication or its contents. 2433 0724/ 3293/3294. timeliness or completeness of any such information. Kasturba Gandhi Marg. Fax + (91 79) 2658 4924 ❏ Hyderabad: Tel +(91 40) 2373 5061/7251. All information contained herein has been obtained by ICRA from sources believed by it to be accurate and reliable. 26. Although reasonable care has been taken to ensure that the information herein is true. Fax + (91 33) 247 0728 ❏ Bangalore: Tel + (91 80) 2559 7401/4049 Fax + (91 80) 559 4065 ❏ Ahmedabad: Tel + (91 79) 2658 4924/5049/2008. express or implied. New Delhi—110 001 Tel. Fax + (91 20) 2553 9231 © Copyright.

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