India's recent investor-friendly changes to additional Tier 1 (AT1) instruments may help the banks to partly fill the sector's large USD 200 billion Basel III capital needs, Fitch Ratings says. But the Indian bank AT1 market remains untested, and the new features may introduce retail investors to a riskier asset class.
The capital requirement also builds in expectations of a pick-up in economic growth, following the advent of a new government with a clear electoral mandate and focus on policy reforms. Banks are still the dominant credit intermediaries in India, and would therefore need to raise capital to support the process of economic recovery. We forecast real GDP to grow by 5.5% in 2015 and 6.5% in 2016.
Large private banks are potentially the best positioned to take advantage of an economic recovery, given their scale, lower funding costs and higher capital levels. They need only 15% of the Basel III capital requirements, and could better fulfil these needs because of stronger internal capital generation and access to equity capital.
Public-sector banks would also benefit from a cyclical recovery, but to a lesser extent - in light of their high exposure to structurally weak sectors. State Bank of India and Bank of Baroda are the best placed among the state-owned banks.
State-owned banks, which represent close to 85% of the capital gap and suffer from weak valuations, would find the capital requirements more challenging. Asset-quality pressures and declining profitability have hurt internal capital generation, thus raising their dependence on state capital. We believe AT1 securities would be likely to have to fill state-owned banks' capital needs in the near term-until improvement is evident in asset quality, profits and their ability to raise core capital.
The Reserve Bank of India's (RBI) amendments to Basel III capital norms include allowing AT1s to have a shorter maturity of up to five years, be temporarily written down at a pre-specified trigger point, and sold to retail investors. These features are more creditor-friendly, and would be likely to draw investor appetite for lossabsorbing capital instruments. But they may introduce moral-hazard risk, as the RBI may be forced to bail out retail investors should there be a need to impose losses.
The recent changes would probably lead the banks to switch to the domestic market for issuance of bank capital instruments, though its ability to fulfil the entire AT1 requirements is still uncertain. The banks would most likely be able to bridge near-term capital needs, but may need to eventually tap overseas markets. Simultaneously, banks will also need to raise core equity, which constitutes another 40% of the total capital requirement.
Early signs of asset-quality stability are emerging at some large state-owned banks, which should be boosted by a pick-up in economic growth. We expect Indian banks' stressed assets to peak by the financial year ending March 2015, led mainly by cyclical recovery. However, improvements will be slow as it will take time to resolve the large stock of problem loans, particularly in the infrastructure sector.
