Valuing zero-interest bonds at FV could coerce 5 PSBs to raise equity/AT1 in the near term

Fair valuing of the equity infused by the Government of India (GoI) in five public sector banks (PSBs) in FY21 through non-interest-bearing bonds could coerce these banks to raise either equity or Additional Tier 1 (AT1) in the near term solely on account of this factor, according to India Ratings and Research (Ind-Ra).

The agency noted that listing zero-interest bonds at fair value (FV) could affect beneficiary Banks’ Tier 1 Capital by 50-175 basis points.

The rating agency said it understands that the five recipient PSBs (Bank of India/ BoI, Indian Overseas Bank/IOB, Central Bank of India/CBoI, UCO Bank and Punjab & Sind Bank/P&SB) may need to value zero-interest bonds (recapitalisation bonds) at fair value instead of par value.

The agency opines that these banks have moderate competitiveness (albeit better than last year) to raise equity and would need to offer materially higher yields to raise Additional Tier 1 (AT1) from the markets.

Valuing these zero-interest bonds at a fair level could coerce these banks to raise either equity or AT1 in the near term solely because of this factor.

Ind-Ra believes the intrinsic net worth of these instruments could be lower by almost 50 per cent at end-FY22 at the outset than similar maturity government papers in the market, given they do not carry any interest. The illiquid, non-trading nature of these securities could add to the discount. 

The GoI had cumulatively infused capital amounting to ₹20,000 crore across CBoI (₹4,800 crore), UCO Bank (₹2,600 crore), BoI (₹3,000 crore), IOB (₹4,100 crore) and P&SB (₹5,500 crore) in 2HFY21, from the budgetary allocation for FY21 through the issue of non-interest bearing (non-transferable) special GoI securities with maturities ranging from 2031 to 2036.

The quantum of capital infusion varied between 11-44 per cent of the Tier I capital of the respective PSBs as of 3QFY21. Equity levels is an important factor in a bank’s ability to service Basel III AT 1 and Tier 2 bonds. 

In Ind-Ra’s estimates, while the impact on P&SB could be substantially high (as high as 5 per cent on CET1 at end-9MFY22), it could be manageable for most other banks that are carrying CET1 in the range of 12-13 per cent (effective CET1 could be lower by 0.5-1.75 per cent).

The agency said with time the discounting factor will decrease, and zero-interest bonds’ fair value will tend to be the par value and affect the banks’ CET1.

In addition, the aforementioned PSBs are in a better shape in terms of capital, provision cover, profitability and net NPA than a year ago.

Ind-Ra had revised the outlook from Negative to Stable on IOB, UCO and CBOI in 3QFY22. Furthermore, these banks have sizable deferred tax assets, the utilisation of which could also release CET1 for these banks over the next few quarters.

Also, the GoI’s planned ₹15,000 crore equity infusion for FY22 is yet to be allocated. However, the contours of the infusion of this amount are not clear.

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