Bank mergers: Are we creating more ‘too big to fail’ banks?

After the Financial Stability Board (FSB) started identifying Global Systemically Important Banks (GSIBs) since November 2011 - the failure of which can impact the entire global financial system - the RBI released framework for dealing with Domestic Systemically Important Banks (DSIBs) in 2014. The failure of these banks can have a significant impact on the domestic economy.

Also read:RBI issue norms on domestic systemically important banks

The critical question is whether the Centre’s move to merge PSU Banks - folding 10 PSBs into 4 - will create more ‘too big to fail banks’?

Read more:Govt banks on big bang mergers as GDP tanks

Currently, the RBI has named three banks — SBI, ICICI Bank and HDFC Bank — as DSIBs, in its March 2019 communiqué. Given that three of the new mammoth entities (post-merger) having Punjab National Bank, Canara Bank and Union Bank as the anchor banks, will have asset size comparable to the existing DSIBs (HDFC and ICICI Bank), the RBI may bring declare them also as ‘too big to fail’ banks (DSIBs).

If bucketed as DSIBs, these banks would require additional capital, and may also have lower leeway to up lending/exposures and expand their balance sheet. That aside, the fact that there will be more banks categorised as DSIBs, only increases the risk in our financial system.

DSIB framework

In November 2011 the FSB had published an integrated set of policy measures to address the systemic and moral hazard risks associated with systemically important financial institutions. It had identified list of global systemically important banks (GSIBs).

While the RBI laid down the framework for DSIBs in 2014, in line with the broad principles of the Basel Committee, its selection was made with an eye on local conditions. For instance, the additional capital buffers to be maintained by DSIBs in India are less onerous than that to be maintained by global banks.

Indian banks need to set aside 0.2 per cent to 1 per cent additional Common Equity Tier 1 (CET1) capital, based on the risk category they fall under. Global biggies in contrast have to set aside 1-3.5 per cent extra capital. Currently there are 29 GSIBs (as per FSB’s 2018 list published in November last year).

In India, the RBI has identified three banks. SBI falls under the third bucket (based on systemic importance scores), which requires it to maintain an additional CET1 requirement of 0.6 per cent. Current CET 1 requirement for all banks is 7.375 per cent (including capital conservation buffer). ICICI and HDFC Bank fall under the first bucket, requiring a lower additional CET 1 of 0.2 per cent.

Post-merger, PNB (with OBC and United Bank), Canara Bank (with Syndicate Bank) and Union Bank (with Andhra and Corporation Bank), would have business of about Rs 15-18 lakh crore and asset base of over Rs 9.5 lakh crore (based on FY19 figures), which would put them on par with HDFC Bank and ICICI Bank in terms of size.

Hence the RBI may put them (one or all) under the DSIB framework, implying higher capital requirement.

In case of PNB, the bank’s CET 1 ratio as of June 2019 is already low at 6.35 per cent---below the regulatory requirement. While the Centre proposing to infuse Rs 16,000 crore into the bank will help, weak finances of the bank and the amalgamating banks (OBC and United Bank) would require the Centre to pump in more capital in future. If the combined entity post-merger is listed as a DSIB, then the capital requirement will only go up.

In case of Union Bank too, given that the bank’s CET 1 ratio as of June 2019 (7.87 per cent) is low and it would merger with weaker banks (Andhra and Corporation Bank), capital needs would remain elevated.

Lower leeway to expand

Given that an underlying cause of the global financial crisis was the build-up of excessive on- and off-balance sheet leverage, despite strong risk-based capital ratios, Basel-III framework introduced a simple and non-risk-based leverage ratio to supplement risk-based capital requirements. The intent was to restrict the build-up of leverage in the banking system.

The leverage ratio is computed as capital (Tier I capital — numerator) divided by the bank’s exposures (denominator). Hence, a rise in exposure would lead to a fall in leverage ratio. If a bank’s leverage ratio falls below the RBI’s threshold, it would serve as a warning signal for the regulator.

The RBI had recently fixed the leverage ratio threshold at 4 per cent for DSIBs and 3.5 per cent for other banks.

The big mergers proposed by the Centre can add pressure on these combined entities to meet the RBI prescribed threshold for leverage ratio.

Going by the latest numbers disclosed in Basel disclosures, individually each of the banks proposed to be merged fall within the threshold (PNB is just about meeting the requirement with leverage ratio as of March at 3.8 per cent).

But the leverage ratio of the combined entities post-merger suggest that these banks may have less leeway to up lending/exposures and expand their balance sheet. For instance, using the March 2019 figures, PNB (after merger with OBC and United Bank) would have a leverage ratio of 4.2 per cent (arrived at by adding each line item of capital and exposure). This would be just above the mandated 4 per cent for DSIBs. If PNB is categorised as a DSIB post-merger, then it could have less scope to increase exposures (higher exposure would lower leverage ratio below the threshold limit).

The biggest challenge for regulators globally, has been the issue of ‘too big to fail banks’, because of which there are tighter regulatory norms put in place for such banks. In India, the big bank mergers could create more such banks--- the failure of which could have a cascading impact on the entire financial system.

COMMENT NOW