Strong loan growth at home and the March 2007 deadline to introduce Basel II rules are giving India’s banks an appetite for capital. At least three public sector banks (PSBs) – Bank of Baroda, Union Bank of India (UBI) and Andhra Bank – will be in the market this year to raise equity capital. ICICI Bank, which is India’s second largest bank and is listed on the New York Stock Exchange (NYSE), completed a $1.6bn offering in December, the largest equity sale by an Indian bank. In May last year, private bank UTI Bank completed a $200m offering of global depository receipts.
The demand for new loans has picked up quickly this year following economic growth of about 8% in the first half of this fiscal year. “After several years of reaping treasury profits from the fall in interest rates, banks are back to making money from their core business of lending, and loan growth is at about 31% this year,” says Cherian Varghese, chairman and managing director of UBI.
Further growth on cards
ICICI Bank’s assets grew by 45% to Rs11,000bn ($25bn) in the year ended September 30, 2005, with retail assets growing at more than 70%, and its capital to risk-weighted asset ratio stood at 11.5%. Given India’s demographic profile and rising income levels, ICICI expects to continue to grow at these rates, says its executive director Chanda Kochhar. That sort of growth is going to keep Indian banks hungry for capital.
A study by Credit Rating and Information Services, the Indian partner of Standard & Poor’s (S&P), predicts that if the proposed Basel II capital rules are applied to the Indian banking sector’s asset portfolio as at March 31, 2004, the banks’ capital adequacy ratio will fall by 1.6 percentage points to 11.3% from 12.9%.
Indian banks have maintained a capital charge for market risk on their securities portfolio from March last year. In February, the Reserve Bank of India (RBI) – the country’s central bank – directed banks to prepare to adopt, at the minimum, the standardised approach for credit risk and the basic indicator approach for operational risk from March 2007. Once that is done, the RBI will permit some banks to adopt the internal rating method to assess the capital charge on their credit risk.
Basel II concerns
The standardised approach relies on external ratings to determine a borrower’s credit risk, and bankers are unsure how it will work. “They are apprehensive that it will either delay credit decisions, cost them too much or that they may not have the necessary historical data on their borrowers,” says UBI’s Mr Varghese, who heads a committee of banks under the Indian Banks Association that is looking at implementation issues of Basel II.
He adds that most PSBs will find it difficult to provide time series data on their borrowers that goes back between five and seven years, the minimum required to assess the probability of default. PSBs’ worry is that the transition to Basel II is likely to be easier for the new private sector banks, which do not have to deal with legacy systems and have more advanced risk-management systems and a smaller loan book. For instance, UTI Bank used the Boston Consulting Group to work on its internal rating system for corporate credit risk and develop a model that it now uses.
“We hope to be among the first banks to be allowed to migrate to the internal risk-based approach once the regulator allows it,” says UTI Bank chairman and managing director P J Nayak. The bank hopes this will lower the capital charge on some of its non-triple-A-rated loans. The burden of implementing Basel II is therefore expected to be heavier on PSBs than on private banks.
The current coalition government’s decision not to privatise the 27 PSBs puts more hurdles in their way. Given its own fiscal problems, the government cannot recapitalise the banks.
“The government will not let its holding in the public sector banks fall to less than 51% and that means that these banks will have to look for new instruments to raise capital, such as issuing preference shares that have no voting rights,” says UBI’s Mr Varghese. UBI is waiting for the securities regulator’s approval to sell new shares, which will dilute the government’s ownership in the bank to about 55.4% when completed, he adds.
Government ownership in Bank of Baroda is also likely to drop to 53% after its equity offering, and to 51% in Andhra Bank. The government’s stake in several other PSBs, such as Oriental Bank of Commerce, Dena Bank and Vijaya Bank, is already between 51% and 53%.
In his mid-term review of monetary policy on October 26, RBI governor Y V Reddy pointed out that Indian banks have limited options to raise capital and the central bank is “examining various types of capital instruments that can be permitted under the new capital adequacy framework”. A senior RBI official said that these instruments could be “hybrid forms of capital”.
In early October, the RBI announced that banks with a capital adequacy ratio of 9% on the risk-weighted assets in their investment portfolio by March 2006 can transfer the balance in the investment fluctuation reserve (IFR) to Tier 1 capital.
Extra capital
The reasoning is clear: the IFR is redundant once banks start to provide for market risk in their core capital. Shifting IFR into Tier 1 will not improve the capital adequacy ratio of banks, but it will allow them to raise more Tier 2 capital (on the expanded Tier 1 capital).
A study by rating firm Crisil says that Indian banks will be able to raise an additional Rs111bn in Tier 2 capital and potentially create another Rs1200bn in risk-weighted assets. PSBs are likely to gain most from this accommodation because they have the largest investment portfolio and IFR.
The central bank, government and banks are working towards sorting out the problems before the Basel II deadline in a way that will not impair their health or compromise their international reputation. Foreign investors own significant stakes in Indian banks and foreign rating firms have commended India’s banking sector in recent reports.
A report issued by S&P in October, India’s Top 20 Banks, says they are fundamentally stronger than China’s banks despite leading Chinese banks having higher credit ratings. The report also points out that the “strong credit quality of Indian banks stands in stark contrast to that of the Chinese banks”. S&P analysts Adrian Chee and Ryan Tsang explain that the rating differential reflects the “readiness of the Chinese government to provide substantial resources through capital injections” to its banks.
The reform of India’s financial sector in the past decade has made Indian banks relatively free from being used as the lending instrument of the state and improved the regulatory and legal environment in which they operate. This has allowed them to develop improved credit-risk management systems and better margins, and to build a stronger capital base compared with Chinese banks, the S&P report points out. But if Indian banks are to grow into truly global banks, the government must let go of them.
