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A quick resolution of YES Bank’s insolvency will keep the India banking sector contagion at bay, though it poses pain for investors in bank hybrid securities, according to a report by S&P Global Ratings.
“As credit markets tighten, we also see a possibility of wider economic pain in the country,” said the report. “We view the Indian government as highly supportive of the banking sector. The Indian government has consistently supported weak commercial banks by promoting the merger of distressed institutions with stronger lenders. The government has historically not allowed commercial banks to fail and has, in the past, swiftly stepped in to address trouble.”
“The current weak economic and high-fear global investment environment” has prompted the government to support the recovery of YES Bank. However, in better times, it would think twice about pushing such a package for relatively small banks, the report added.
SBI will own a minimum of 26 per cent of YES Bank for the next three years. Its ownership should give confidence to depositors and lenders about the bank’s solvency, the report added.
AT1 risk premiums to spike
The risk premiums for additional tier 1 (AT1) instruments of private sector banks in India are expected to spike in the aftermath of the YES Bank bailout.
“As per the proposed draft reconstruction scheme, YES Bank’s AT1s will be entirely and permanently written down. The write-off of AT1s is in line with our view that these instruments will absorb losses at private sector banks, unlike public sector banks,” it added.
AT1s, a hybrid instrument designed to protect banks during distress, will absorb the maximum loss. This may increase the risk premium on the tier 2 subordinated bonds of all Indian banks, said the S&P report.
The Centre is working with State Bank of India to inject capital into YES Bank, a troubled private sector bank with 1.8 per cent of the country’s bank deposits (as of March 31, 2019). It had earlier put YES Bank under moratorium, restricting its operations and capping deposit withdrawals at ₹50,000 per account. This gives the government time to rescue the lender. Under the draft reconstruction scheme, SBI will infuse capital into the bank and acquire up to a 49 per cent stake.
The events follow YES Bank’s failure to raise capital to address loan losses, sparking a withdrawal of deposits. The RBI has highlighted serious governance issues at YES Bank, lapses that have contributed to the institution's steady decline in recent years.
Contagion risk
If YES Bank’s resolution process is prolonged, there is a risk the broader banking environment may take a hit. This may raise investors’ perception of credit risk in the system, tightening funding, said the report.
Many mutual funds hold YES Bank securities, including subordinated debt and AT1s. A depreciation in the value of these instruments would hurt credit funds, potentially triggering capital outflows. This could widen spreads and drain the credit available to lower-rated entities, it added.
The uncertainty may engulf weak financial-sector entities, including non-bank finance companies and private-sector banks.
“In the past, in the cases of bank failures — such as the collapse of Global Trust Bank Ltd, Nedungadi Bank Ltd, United Western Bank Ltd, Bank of Rajasthan Ltd and Sangli Bank Ltd — we have seen swift action that nipped the contagion in the bud,” the report said.
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