Private banks are not constrained to raise equity unlike public sector banks.

With the introduction of Basel III norms, Indian banks’ minimum capital requirement, as a proportion of risk-weighted assets, is set to rise in the next six years. This could apply pressure on the return on equity of Indian banks, especially those in the public sector. Given that banks need to have core equity (shareholder funds) in excess of 8 per cent by 2018, the ability to leverage may also be limited going forward.

Why Basel III?

After the financial crisis of 2008, many financial institutions had to be bailed out by their respective governments. This necessitated stricter regulations, including higher capital requirements for banks to weather future shocks relatively better.

The Basel Committee on Banking Supervision in December 2010 introduced the Basel III rules which consist of higher core equity requirement (common shareholder funds), higher leverage ratios (tier-1 capital-to-total exposure), bringing more instruments into coverage and maintenance of liquidity ratios.

RBI’s conservative stance

The Basel committee recommended a capital adequacy ratio of 8 per cent (excluding counter cyclical buffer) for global banks as compared to 9 per cent stipulated for Indian Banks.

Indian banks also have to maintain leverage ratio (tier-1 capital as a percentage of total exposure — both on-balance-sheet and off-balance-sheet) of 4.5 per cent as compared to the Basel committee’s recommendation of 3 per cent. The RBI’s timeline to implement Basel III capital requirements is also slightly ahead of the Basel committee’s recommendation.

How are Indian Banks placed?

All banks need to have core equity ratio to risk-weighted assets of 9.5 per cent by March 2018.

As of March 2012, the tier-1 ratio of Indian banks is estimated at 9.8 per cent, predominantly driven by high capital levels of private banks which have tier-1 ratio of 11.6 per cent. PSU banks have tier-1 ratio of 9.3 per cent. Private banks seem to be in a better position than their PSU counterparts for the following reasons.

One, most private banks have tier-1 in excess of 9.5 per cent. In comparison, 14 of the 24 public sector banks have tier-1 ratio of less than 9.5 per cent. More numbers of banks would have had lower tier-1 ratio had the government and LIC not infused capital in a few PSU banks in March 2012.

Two, private banks’ tier-1 capital largely consists of core equity (shareholder funds). While the RBI has estimated that around 15 per cent of the tier-1 ratio of the banking system is not core equity, much of it is held by public sector banks.

UCO Bank, Vijaya Bank, Central Bank of India and Bank of Maharashtra are a few banks which hold a higher proportion of non-core tier-1 capital.

Three, while it is a given that both public and private banks require equity infusion from time to time, private banks aren’t constrained to raise equity unlike public sector banks. Public sector banks have limited ability to raise capital since the government would prefer to maintain majority share.

Nine out of 21 listed banks (excluding SBI’s associates) have government shareholding of less than 60 per cent. Again, a higher fiscal deficit reduces the ability of the government to infuse capital.

This limited ability of the public sector banks may lead to lower growth in advances which may in turn lower their market shares.

Further, according to Basel III requirements, all banks need to deduct unamortised pension liability from tier I capital by January 2013.

Nevertheless, all is not lost for public sector banks. There is headroom worth Rs 70,100 crore for public sector banks (even at these valuations) to raise fresh equity (at current prices) and yet maintain 51 per cent of the government holding. A revival in the equity market may play a major role in raising capital.

Retained earnings will play an important role in shoring up equity. For instance, in the last four years, listed public sector banks paid Rs 34,000 crore or a little over one-fifth of their profits in the form of dividends.

If the banks manage to retain most of their future earnings, this would take care of some proportion of their capital-raising needs.

For all banks which pay dividends, if earnings grow by 10 per cent compounded annually from here on, they can add more than Rs 67,000 crore to core equity by not paying dividends.

Additionally, given that these retained funds will also earn returns, the actual benefit may be higher.

Valuation to be impacted

Lower leverage due to these proposals can lead to a lower return on equity and valuation. Growth in earnings may also moderate given the higher equity requirement and lower growth in assets (due to conservation of capital).

But, the point to note is that higher equity will make exposure less risky from a creditors’ point of view. Many rating agencies have pointed out that the Basel III norms are positive in terms of credit rating.

This would lower the cost of borrowing in domestic and international markets (given stricter regulations and higher equity contribution than its global peers). The moderation in cost of borrowing may partly offset the decline in ROEs.

(This article was published on June 23, 2012)
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