Financial platforms, which include both institutions as well as markets, always have surprises for the participants. Normally when one enters the equity market, the risks are known. In the case of debt markets, too, there can be uncertainty of default as the NBFC saga demonstrates. Mutual funds are the agents of the retail class and help to bridge the knowledge asymmetry gap.

But when we talk of money kept in banks, it is assumed to be safe. While the PMC episode did ring a wakeup call on deposit insurance, other instruments like bonds issued by banks did not quite catch one’s attention.

Two episodes of bonds issued by banks to shore up their capital have raised issues for broader discussion as they have been valued at zero. YES Bank had AT1 bonds which were of the order of ₹8,400 crore and LVB had Tier 2 bonds for a lower amount of ₹320 crore.

The storyline was similar in both the cases. Mounting NPAs, higher provisions and erosion of capital leading to a rescue plan by the RBI, which meant other banks stepping in. Deposits were protected while the capital-based bonds were written off.

Essentially, both AT1 bonds and Tier 2 subordinated debt are issued in perpetuity or with long tenures and carry higher rates of interest than deposits. However, they are completely unsecured and carry no support in case of default. This is hence analogous to equity which in extreme cases can be reduced to zero value.

The LVB bonds carried interest rates of 10.7-11.8 per cent while the AT1 bonds of YES Bank had rates around 9.5 per cent. The RBI has clearly mentioned that these bonds are unsecured and have no cushion to fall back on. They are, in fact, the first instruments for write-off when a crisis emerges.

Comfort for bond holders

While it has been argued that some comfort should be given in the form of conversion to equity, the terms of issuance are clear about their status. In case of failure, these bonds need not be serviced or returned.

Two things would now happen. First, banks will find it that much harder to raise such bonds; for weak banks at ‘all times’ and for strong banks during difficult times. The AQR phase, for example, was tough on banks which had to confront rising NPAs. At this stage, raising capital through AT1 bonds or Tier II bonds was a way out but in future may create fear in the minds of investors including mutual funds, provident funds, pensions, insurance companies.

Second, from the investor’s perspective, there would be concern because even if one is aware that these bonds need not be serviced at the time of a crisis, it is assumed that such situations would never occur. As investors are typically institutions or high net worth individuals where the minimum size of investment was ₹10 lakh (which has been raised to ₹1 crore), the question would be whether taking a risk for probably 200-400 bps return is worth it.

In fact, going ahead it is not hard to conjecture weaker banks, including PSBs, facing such an action. The government has been trying to make them stand on their feet without a crutch. What stops the government from asking them to stop servicing these bonds in case the net worth gets wiped out?

Banks have been periodically exposed to NPA cycles which have hit their foundations quite hard. Therefore, this question will come up at some stage as merger of banks gather momentum as well as probably privatisation. Banks may just decide to write-off NPAs with a corresponding entry on the liability side through the erosion of these bonds.

Should such bonds be permitted? The Basel framework allows the issuance of such bonds within limits and hence it is a global practice. Just like how equity and reserves can be written off, so can any other form of capital which includes these bonds in case of insolvency. Therefore, not allowing such issuances is not an option.

But can these limits be controlled or monitored closely? This is important because ideally banks must be forced to bring in equity to increase their CRAR. There are strong proponents of this view as it increases the owners’ skin in the game. By permitting the issuance of such debt, the equity owners maintain their stake and hive off the risk to the debt holders. Therefore, there is a school that believes that such debt should not be permitted.

One way of addressing issues of such bond holders is to have checkpoints on these ratios such that every time the net worth gets affected, banks must be asked to raise more common equity so that they do not reach a stage where these bonds have to be written off. Hence, just like how there is a criterion set for PCA banks, thresholds can be set to make them raise more equity.

This will mean that the government must get in more funds for PSBs when their profits decline due to problems on the NPA front.

It is necessary to review the terms of issuance of these bonds. SEBI has quite appropriately addressed the investor side by keeping them open only for non-retail participants. But from the point of view of issuer, it may be worthwhile having some objective monitoring.

Bank failures look more likely in these times especially for niche players and M&A activity in future cannot be ruled out. Holding bonds of weak banks may hence not be an option for institutional investors who prefer to go in for higher rated debt. Who then will subscribe to these bonds?

The writer is Chief Economist, CARE Ratings. Views are personal