Centre’s timely capital cushion saves PSBs from bond bust

In the latest, June, quarter Indian Overseas Bank’s capital ratio slipped below the mandated 9.47 per cent. If it were not for the government’s capital infusion of ₹3,100 crore (half earmarked for immediate injection), the bank would have defaulted on the interest payment of its bonds.

The Centre infusing capital into public sector banks (PSBs) at the start of this fiscal, aside from helping banks plan their lending activity and capital-raising efforts, appears to have also come to the rescue of capital-crunched banks on the verge of defaulting on their bond payments.

Finding it difficult to tap the capital market PSBs have been raising funds by issuing Basel III-compliant bonds — Tier I and Tier II.

The sharp rise in banks’ bad loans over the past year and the Basel III regulation requiring them to step up their capital ratios turned real the prospect of default by banks on these bonds.

The unique feature of these bonds is that banks have the discretion to defer interest payments if their capital ratio falls below the regulatory requirement.

Currently, banks have to maintain a total capital ratio of 9.625 per cent, up from 9 per cent last year. IOB’s capital predicament came on the heels of Dhanlaxmi Bank deferring payment of interest on its bonds, after its capital ratio fell below the mandated level in March 2016. Sadly Dhanlaxmi Bank, a private lender, did not have the government’s backing.

On the brink Since March, most PSBs’ capital ratios have dipped and a few are just about keeping the head above water. For instance, United Bank, UCO Bank and Central Bank of India had a total capital ratio of around 9.9 per cent as of the June quarter.

For these banks, the bad loans have been steadily on the rise with more pain expected in the coming quarters. However, the Centre infusing ₹800-1,700 crore into these banks this fiscal can help them meet their capital needs.

Nonetheless, this does not take away the risk that worsening asset quality of PSBs poses to investors in bank bonds. Aside from the discretion of coupon payments, there are other risks that these bonds carry.

For instance, in the case of Tier I bonds, the principal can be written down on breach of a pre-set trigger. Tier II bonds under Basel III too can result in loss of principal to investors.

Rating agencies, hence, factor in all these risks and rate such bonds a few notches below the bank’s Corporate Credit Rating (CCR).

Rating the risk According to Krishnan Sitaraman, Senior Director, CRISIL Ratings, “The extent of such ‘notch-down’ will depend on factors like the bank’s profitability and cushion for asset-side risks, the management philosophy, and track record of maintaining sufficient capital cushion above the minimum regulatory requirement and adequacy of revenue reserves to service coupon in times of sudden stress.”

CRISIL, for instance, has assigned ‘A-/negative’ rating to IOB’s Tier I perpetual bonds (Basel II) which implies adequate safety regarding timely servicing of financial ligations and moderate credit risk.

The term ‘negative’ indicates a negative outlook. Rating on Tier II bonds — that carry lower risk — could typically be rated at the same level as the CCR or a notch lower, adds Krishnan Sitaraman.

In March 2016, CRISIL had downgraded the ratings on IOB’s debt instruments. The rating downgrade reflected significantly higher-than-expected deterioration in asset quality and profitability.

Nevertheless, the ratings also factored in CRISIL’s belief that IOB will continue to receive support from its majority owner, the Government of India, both on an ongoing basis and in the event of distress, according to a note put out by the ratings agency.