Suresh Krishnamurthy

THE Left parties' insistence on the Government retaining 51 per cent stake in public sector banks has prepared the ground for the introduction of preference shares as a source of capital for Indian banks.

But funds mobilised through preference shares, and convertible instruments if they too are allowed, will not just substitute equity. Such mobilisation could have unintended consequences on strategies of banks and their profitability. The trend could also expedite consolidation in the banking landscape. Initially, at least, it could also lead to a re-rating of the price to earnings multiple of banks.

Impact of preference capital

Consider the impact of preference capital on a bank's profitability. Now, because of the minimum capital requirement rules, banks could at the most increase their debt-equity ratio to about 13:1. With public sector banks struggling to generate return on assets of about 1.2 per cent, the maximum possible return on net worth (return on assets multiplied by debt-equity ratio) would be pegged between 15 and 16 per cent.

Let us suppose, RBI allows banks to issue preference capital up to 20 per cent of tier-1 capital and banks raise preference capital at a rate of 10 per cent. In such a case, preference dividend paid will reduce the return component for return on assets. However, since leverage of equity funds increases, return on net worth will also expand. This is because the same amount of capital supports a higher volume of business generating higher profits. Expansion could be of the order of nearly 2 percentage points. In addition, 10 per cent is a significantly high rate. Banks are likely to be in a position to raise long-term preference shares at coupon rates between 6 and 8 per cent. Impact on bank profitability could thus be significant.

This scenario, however, assumes banks utilise capital efficiently. That is, banks would accumulate risk assets at the optimal pace. Penalty for inefficient use of capital funds, though, will increase. For instance, return on net worth gains will evaporate completely even if leverage dips by a mere 10 per cent. Evidently, raising preference capital may change bank behaviour. Only banks with strong risk management systems in place will be able to make the most of the changed scenario.

Currency for acquisition

Another consequence is on the consolidation front. Preference capital can be used as the currency for acquisition. The advantage for public sector banks is that they no longer need to bother about Government stake falling below 51 per cent. Public banks can now think of even acquiring old private sector banks. At the same time, smaller or weaker banks may also find it easier to access capital through the preference capital route. They no longer will need to consider M&A as the only option for survival. Thus, the costs of acquisition could go up too for larger banks.

Banking system's requirement of capital is set to rise sharply. A study by the Indian Banks' Association estimates that total assets of banks could double to Rs 41 lakh crore by 2010. It is possible that even this is an under-estimation. This is because bankers do not appear to have satisfied the demand for credit from each and every possible segment in the lending universe be it retail or agriculture or the corporate sector. Rapid accumulation of risk assets has thus become a near certainty.

While preference capital provides the answers to these questions on the capital front, it also unleashes other forces that could potentially change the banking landscape. Managing these changes could offer another challenge to the Reserve Bank of India that has shepherded the banking sector through difficult times.

(This article was published in the Business Line print edition dated January 26, 2006)
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