Adding equity muscle to banks

These are testing times, indeed, for Indian banks. On the one hand, a slowing economy and repayment stress experienced by corporates have led to a piling up of bad loans. The so-called gross non-performing assets of the banking industry are estimated to have crossed 3 per cent of their total advances. The ratio would probably be twice or more if one also includes cases of ‘corporate debt restructuring' that entail bailouts to troubled borrowers by way of interest rate reductions or rolling over repayment obligations. In such a scenario comes the Reserve Bank of India's (RBI) move to issue the final guidelines for implementation of the latest Basel-III international banking capital regulation norms.

In overall terms, the minimum capital adequacy ratio (CAR) norms under the new guidelines are not different from the existing stipulation of 9 per cent. Indian banks, in any case, have already achieved a CAR in excess of 13 per cent. But the new norms are not as much about the quantity as the quality of the regulatory capital of banks. Under Basel-II, only 3.6 per cent of the overall 9 per cent CAR had to come from common equity, consisting of their paid-up capital and various reserves. But the RBI guidelines for meeting Basel-III norms mandate a minimum common equity component of 5.5 per cent. Further, an additional 2.5 per cent of such equity has to be provided as ‘capital conservation buffer' against any unforeseen contingencies. That takes the aggregate CAR to 11.5 per cent, of which common equity alone – the form that imposes the highest level of returns for a unit of banking capital– would constitute 8 per cent. Given the state of risk appetite among investors today, it is also the hardest to mobilise. In this case, it involves raising huge sums of capital, estimated in the region of Rs 200,000 crore, roughly four-fifths of which relates to state-owned banks. They would, then, have to float fresh equity resulting in a dilution of the Government's stake. Alternatively, the Government may have to pump in the capital itself or rationalise its dividend policies to enable banks to conserve more cash in their business. Either way, they impose fiscal costs on taxpayers.

While implementing Basel-III may not be easy in the current economic context, one would still support it from a larger financial stability perspective. Indian banks were well-capitalised at the time of the 2008 crisis and that inspired all-round confidence in their (and also the country's) financial solvency. The same confidence needs reinforcement in these renewed times of global uncertainties, topped by investor concerns that are specific to India. Also, the fact that the additional capital mop-up is to be done over six years – and much of it after 2015 – can help somewhat smoothen the transition. A policy decision on the Government relinquishing majority stake in its banks will make things easier.