The Hindu Business Line : Innovative instruments

FACED WITH THE constraint of retaining Government stake in public sector banks at 51 per cent to comply with the higher capital adequacy requirements under Basel II norms, the Reserve Bank of India has now allowed banks to raise capital through the issue of what it calls `innovative instruments'. New instruments for inclusion in Tier-1 capital, such as perpetual debt and preference shares, are new to the Indian capital market. Long-term debt, with a term to maturity of over 15 years, which would be included in Tier-2, is not new but still extremely rare. As the central bank has surmised, about Rs 1,00,000 crore can be raised through the issue of these instruments in the next few years, ushering in a new era in the capital market. With total assets of the banking system expected to double, and with risk assets growing at about 30 per cent, the expansion of capital-raising options has not a come a day too soon.

Chairmen of public sector banks can now breathe easy. They can go ahead and raise capital to meet growth requirements. The Government stake in at least three public sector banks is at 51 per cent but all three would need infusions of capital in the next 12 months. Also, banks need not wait for an amendment to the governing Acts, as they are not dependent only on preference shares. They can now issue perpetual debt and long-term debt to shore up their capital adequacy. And that needs no change in the legislative framework.

These innovative instruments will help banks increase their leverage, with a lower level of equity capital supporting greater business volumes. This could increase banks' profitability, laying the ground for a re-rating of stocks in the sector. Banks, though, would need to use capital more efficiently. Inability to accumulate risk assets at the right pace could drag down profitability considerably, while piling up such assets too quickly can bring its own problems. Risk management systems need to be working at their best. For the regulator, the introduction of non-equity capital and the penalty that is imposed on slow-growing banks poses its own threat. In typical style, the RBI has sought to address this by specifying that innovative instruments cannot exceed 15 per cent of Tier-1 capital. If the experience in the next few years is satisfactory, the apex bank would increase the proportion.

Will there be an appetite for perpetual instruments? They are popular abroad, where insurers and pension funds are major investors in them. Banks may find such investors in India too. Besides, cross-holding of up to 10 per cent of the capital funds of a bank by another bank is permitted. So, even if investor appetite is lukewarm, public sector banks would be able to ensure subscription to these issues. Allowing the issue of innovative instruments could also pave the way for consolidation in the banking sector. Banks could raise capital in the form of these instruments to acquire other banks. They could also offer these instruments with attractive terms to shareholders of the target banks. Hybrid capital has been used overseas to finance acquisitions. All of this is slowly, but surely, ushering international practices into the Indian banking landscape.