The new regulatory cap on banks’ exposure to their own group entities will help contain possible contagion from the failure of a group entity to core commercial banking operations, India Ratings & Research said in a report.

The agency does not expect the new regulation to have any immediate negative rating impact on Indian financial companies, which derive creditworthiness from their parent banks’ willingness and ability to provide timely and adequate support.

“Rules limiting capital impairment from the failure of an internal group entity are viewed to be positive, especially as some group entities may have elevated exposure to sensitive sectors. Typically, non-bank finance companies (NBFCs), housing finance companies, broker-dealers and insurance subsidiaries/joint ventures of banks are rate-based on the expectation of extraordinary liquidity and/or equity support from parent banks in case of a crisis,” India Ratings said in the report.

The new guidelines will limit access to liquidity support for such group entities and the cost of equity support remains high; equity investments in a group entity over the prescribed limit is deducted from the bank’s regulatory capital. However, most group companies of Indian banks are small and the exposure cap at 10 per cent of the parent bank’s capitalisation is unlikely to have a negative impact in the near to medium term, it said. 

India Rating believes that a bank’s refinancing capability could come under severe pressure from the failure of a core or strategically important group entity. Future earnings potential may also be diluted if the failed entity was a provider of important services in a financial group’s product portfolio. Hence, keeping such entities soundly capitalised on an ongoing basis will become increasingly important as the capability of parent banks to provide emergency liquidity support diminishes.

 

Also, a parent bank’s capital strength will become an even greater determinant of its ability to provide extraordinary support. In this context, a clearly outlined support stance for the entities identified as critical to group operations would provide significant comfort to creditors.

The new regulatory prescriptions require banks to limit their overall non-equity exposure to group entities at a maximum 20 per cent of their equity, with sub-limits for individual and non-financial entities. If banks do not meet these requirements by March 2016, exposures in excess of the allowed limit will be deducted from the bank’s common equity Tier-1 capital.

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