The government remains unwilling to allow state-run banks to miss coupon payments on Additional Tier 1 ( AT1 ) instruments, going by the ₹1,861-crore capital injection into IDBI Bank, according to Fitch Ratings.
It said the capital injection into IDBI Bank, which reported substantial losses in the FY17 and in its first quarter results, on August 9, ahead of first quarter earnings announcement, underscores that the authorities have little appetite to force a coupon skip by a large state-owned bank.
The credit rating observed that IDBI Bank may have been at risk of skipping a coupon payment without the fresh capital, which might have disrupted the domestic AT1 market and made it more difficult for banks to raise the capital needed to meet Basel III minimum requirements.
The cost the government faces in recapitalising state banks could potentially rise if access to the AT1 market weakens, it added.
“Investors in AT1 instruments are clear beneficiaries of capital injections and other forms of forbearance, but senior creditors typically would expect any future losses to be cushioned by AT1 investors first taking losses.
“These policies also create moral hazard by weakening the pressure AT1 instruments should put on banks to recapitalise by raising equity on a more timely and pro-active basis,” the agency said.
Fitch assessed that the yield spreads between Indian AT1 instruments and gone-concern Tier 2 debt have gradually tightened over the previous few years. The narrowing has been largely driven by market expectations of forbearance as well as strong AT1 demand from mutual funds, which received a surge in liquidity after demonetisation brought cash back into the formal financial sector.
According to the agency, other state banks have previously received capital injections from government to stave-off skipped coupon payments after coming close to breaching minimum capital adequacy requirements.
“There have also been several regulatory adjustments in the previous few years that appear to have been timed to avoid potential damage to sentiment in the AT1 market. Most recently, the Reserve Bank of India decided earlier this year to allow banks to use their statutory reserves to pay coupons on AT1 instruments after losses left some banks lacking distributable reserves.
“These policies are in response to persistent banking sector losses and weak internal capital generation that will continue to put some banks in danger of breaching minimum capital adequacy ratios, which are set to rise further with the implementation of the Basel III framework over the next two years,” Fitch said.
Market pricing (on AT1 instruments) appears to assume that the government is likely to continue to ensure state banks do not miss coupon payments, the agency said and added that there is some pricing distinction between the larger and smaller state banks, but the small premiums on their AT1 instruments suggest pricing is now largely based on assumptions of state support being provided ahead of banks triggering non-performance clauses.
Fitch continues to believe that private banks will be allowed to skip coupon payments, but most are in relatively healthy positions.
The agency felt that increase in AT1 issuance so far this year suggests (RBI) forbearance is paying off in terms of addressing capital shortfalls. AT1 instruments worth around ₹18,300 crore have been issued by eight banks in April-August, compared with ₹4,800 crore by four banks over the same period in 2016.
However, banks are likely to need substantially more than that by financial year ending 2019 to meet rising Basel III minimum capital requirements and the government is likely to end up providing much more than the $10.4 billion already earmarked