Moody's downgrade of India's largest bank State Bank of India to a D+ from a C- led to an eight per cent correction in the scrip over the last one week. In a risk-averse environment, the move spooked investors and got them questioning the sector as a whole. The BSE Bankex was also subject to selling pressure with the index down by 8.2 per cent by the close of Wednesday's trade. However, the index did manage to pare losses by the end of week with a 4.6 per cent gain on Friday.

Question of capital

Moody's downgrade reflects concerns on whether depositors are sufficiently shielded from possible losses arising from loans turning sour. The question is: does SBI have sufficient levels of capital to protect investors?

Moody's says no, the bank does not have enough capital backing the loans it has made out . Such a scenario may heighten the danger in risky assets in a slowdown. SBI's loan book has gross non-performing assets (NPAs) of 3.5 per cent and restructured assets of 4.5 per cent (which partly have slipped into NPAs). These two numbers could prove worrisome if asset prices continue to fall. And given the current market conditions, this is a very real possibility.

In addition to setting aside capital to provide for bad loans, SBI has also had to provision Rs 8,000 crore of its capital (including reserves) for shortfalls in its employee pension fund. The most damning comment, however, is that the bank's largest owner, the Government of India, is lethargic in its efforts to invest more capital in the bank to bolster its position and provide a larger cushion for losses.

This, Moody's believes, makes SBI a riskier entity to lend to. The ratings agency opines that even a proposed Rs 23,000 crore capital infusion will barely meet the bank's funding requirements for growing its loan book over the next three years.

Fund raising

SBI has been angling to raise funds of around Rs 23,000 crore through a rights issue over the next few months. This would require the government, which holds just under 59 per cent, to invest around Rs 13,800 crore in the bank.

However, at the start of the ongoing fiscal, the government had committed only Rs 6,000 crore to recapitalizing all the public sector banks it owns! At the same time, the government is unwilling to allow SBI to raise capital through means which may dilute its stake in the banking behemoth. This may be because SBI's status as a public sector entity would then be compromised. The Finance Ministry is reported to be taking a hard look at SBI's books to determine if the bank is being stricter in what it calls bad loans or provisioning, than it really ought to be.

Fallout

The Moody's move will make it more expensive for SBI to tap overseas markets to raise capital or funds. However, Moody's was beaten to the punch by the CDS (Credit Default Swaps) market in spotting SBI's emerging difficulties. The cost of insuring SBI bonds against a default had been rising in the one-month period leading to the downgrade. That may explain why, post the downgrade, swaps have been relatively stable compared to the sinking stock price!

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