* Investors shun new style subordinated debt
* Lack of understanding, tight pricing blamed
* Banks need INR5trn in capital by 2018
By Manju Dalal
Dec 7 (IFR) - A lack of interest from investors is threatening to derail the efforts of Indian banks to raise the additional capital they need to comply with tougher Basel III rules.
The first sales of Basel III-complaint subordinated bonds flopped after a resounding rejection from investors. Now, bankers are unsure if any institution will be able to muster demand for the new products for at least the next six months.
"We tried, but the only reaction we got from investors was: 'Basel III - what kind of animal is this'?" said the head of debt capital markets at a private sector bank.
His bank attempted to sell a new-style sub bond last week, but was eventually forced to revert to the tried-and-tested Basel II structure - even though it will lose 10% of the capital benefit from the notes each year from January 1, when Basel III rules kick in.
Central Bank of India, Oriental Bank of Commerce, United Bank of India and even ING Vysya Bank have all tried and failed to sell Basel III-compliant bonds in the past few weeks.
The Indian banking sector may be among the most in need of a capital boost under the new Basel III regime. Yet, it is becoming clear that it is also one of the least prepared for the transition.
If local markets continue to be unavailable for fundraising, banks may need either to pay up to access overseas capital or shrink their loan books.
"The transition to Basel III is not coming at a good time for Indian banks as they are facing asset-quality issues and the overall business outlook looks grim," said another banker.
There are several hurdles to these new bonds in India, not least being the lack of understanding on the buy side.
The loss-absorption features required for sub bonds to count towards Basel III capital may put the paper beyond the reach of investors like pension funds and insurance companies, if their funds are not allowed to invest in equities.
To qualify as additional Tier 1 or Tier 2 capital, bonds will need to write down to zero if the RBI deems a bank to be non-viable, forcing sub bondholders to wear losses before any public funds are used in a bail-out.
This feature means credit ratings on the Basel III-compliant instruments will also be lower than investors are accustomed to on the old-style notes, making the new ones inaccessible to some institutional investors with statutory limitations to invest only in debt rated Double A or above.
Then, there is the price issue.
"Under Basel III guidelines, perpetual bonds will need to have a loss-absorption clause, which implies higher risk for investors in these instruments. Investors will need to be compensated for the increased risks by offering higher coupons on these instruments," said Pawan Agrawal, senior director, Crisil Ratings.
Price-sensitive Indian issuers are still not ready to face that reality. For instance, United Bank of India, rated AA (Crisil), had pitched a Basel III-compliant Tier 1 perpetual to investors at a price in line with the old-style bonds.
After investors pushed back, the lender eventually priced the issue under the old-style Basel II format on November 30. The bank raised INR3bn from perp bonds, callable after 10 years, at 9.27%.
After January 1, banks like UBI will have no such fallback. Without a loss-absorption clause, no new bonds will count towards Tier 2 or Tier 1 capital once the Basel III deadline passes.
Even though lobbyists have asked the regulator to delay the implementation of Basel III, the Reserve Bank of India is not relenting.
"RBI considers itself flag bearer of changes and it does not care if the markets are ready for these changes," said another banker.
Under its version of Basel III, the central bank will require lenders to hold a minimum common equity ratio of 8% and a minimum total capital ratio of 11.5%. RBI estimates that Indian banks will need to raise INR5trn (USD91.8bn) before March 2018 to comply with the tougher capital requirements.
Public sector lenders will receive some of the additional equity from the government, but the RBI expects nearly INR3.25trn to come from the bond markets in the form of non-core capital.
That figure matches estimates from local rating agency, Icra, which estimated in May 2012 that Indian banks would be required to issue INR1.9trn of additional Tier 1 of and INR1trn of Tier 2 capital.
As a result, market participants are saying that Basel III will be a catalyst for a major consolidation in the industry as many weaker banks will not be able to meet the RBI's more stringent guidelines. (Reporting By Manju Dalal; Editing by Steve Garton and Christopher Langner)