Akash Prakash: Capital cliff ahead

Last Updated: Fri, Dec 07, 2012 07:40 hrs

p ppGlobal financial markets are waiting with bated breath to see whether the US economy goes off the &ldquofiscal cliff&rdquo The fiscal cliff refers to the automatic tax hikes and spending cuts that will kick in by the end of the year unless policy makers in the US can agree to compromise and find a path towards long-term fiscal sustainability If no compromise is reached then most market observers expect the US economy to slip back into recession in 2013 The spending cuts and tax hikes could reduce 2013 growth by two or three per cent of gross domestic productppAlthough India does not have to deal with a fiscal cliff it does have an upcoming capital cliff in the banking sector especially for public sector banks PSBs The Reserve Bank of India RBI has decided to go ahead and implement the Basel III norms between 2013-14 and 2017-18 and has in fact prescribed guidelines that are a little tighterppAs Rajeev Varma of Bank of America Merrill Lynch has pointed out in a recent note the Indian banking sector has huge upcoming capital needs Mr Varma points out that by making some basic assumptions about credit growth 16 or 17 per cent for PSBs profitability he actually assumes that PSBs&rsquo profitability rises from here and the minimum capital ratios banks must get 10 per cent tier I by 2018 regulatory minimum will be 95 per cent one realises that Indian banks have huge upcoming capital needs His calculations indicate that the Indian banking system will need almost 40 billion of additional capital by 2018 Various other analysts have also come out with similar numbers Even the RBI has talked of such large numbers in its various reports Thus Mr Varma is not an outlier nor do his calculations or assumptions stretch credulity In fact one can argue that the numbers will be even larger if we assume that the RBI goes ahead and implements higher provisioning norms for restructured assets and some form of dynamic provisioningppOf 40 billion nearly 30 billion will have to be raised by PSBs which looks to be a tall order Given that the government insists on maintaining a minimum 51 per cent stake in these banks the majority of this 30 billion will have to come from the government&rsquos own coffers The government&rsquos current fiscal position makes it unlikely that it can afford another 15-20 billion capital call obligation over Rs 1 lakh crore For a government trying desperately to cut its fiscal deficit to three per cent of GDP you must really wonder where the money will come from If the money were to be made available is this really the best use of scarce resources There seems to be no political will to cut these banks loose and bring the government&rsquos stake down to below 51 per cent thus lowering the burden on government financesppHowever even if the banks were told to rely entirely on the financial markets for this money the difficulties would not diminish For certain PSBs like IDBI Corporation Bank and UBI the capital needed for Basel III is greater than their current total market capitalisation It is obviously very hard for any business entity to raise new chunks of capital greater than your current market capitalisation For other PSU stalwarts like Punjab National Bank Oriental Bank of Commerce and Bank of India the amount of capital needed is equal to about 65 per cent of current market capitalisation The only two large PSBs for which these ratios seem reasonable are State Bank of India and Bank of Baroda here the amount needed is large in absolute terms 10 billion for SBI and 25 billion for Bank of Baroda but is only 35 per cent of market capitalisation for SBI and 40 per cent for Bank of Baroda Both banks also have investors&rsquo support and so they will be able to raise the capital neededpp For private sector banks the amount of capital needed is about 10 billion compared to their combined market capitalisation of about 85 billion So it is not out of the realm of possibility These banks are also seen as structural market share gainers with a high return on equity Thus investors are happy to provide them with as much capital as neededppIt is true that these capital needs are required till 2017-18 and are thus spread out However if banks were forced to dilute every year to minimise any single-year burden on government finances they would risk antagonising investors who don&rsquot want to support continuous and unending annual dilutionsppWhat is likely to happen of course is some type of fudge The RBI will either delay &ndash or water down &ndash the implementation of Basel III and give everyone more time or lower the capital bar itself The RBI may also permit some kind of quasi-equity hybrid instruments to be counted as capital though the wiggle room under the new Basel III guidelines is limitedppAlternatively if the RBI does not budge then PSBs 75 per cent of our financial system will be very constrained in their asset growth They may find it difficult to achieve more than 12 to 14 per cent asset growth given the capital constraints they are likely to face If 75 per cent of the banking system cannot grow very fast either the country cannot support our desired eight per cent growth or the private banks will have to take up the slack and grow at upwards of 30 per cent a huge opportunity given their ability to raise capital The sector with the biggest impact will be the small- and medium-enterprise space where PSBs dominate Private banks have been hesitant to fund these small companies aggressively and they will find their limited access to capital further constrained as the private banks drive credit growth for the systemppThis upcoming capital cliff might also force the much-discussed consolidation among banks Many banks with no hope of raising the amount of capital required will have no option but to merge with larger brethren who can attract the capital they needppWe as a country are going to need huge chunks of equity capital across sectors We have already discussed the dire state of balance sheets in which the infrastructure players find themselves and their need to de-lever Now the banks need over Rs 2 lakh crore of equity &mdash and the story is repeated across sectors India may remain a stock-specific market with the huge deluge of equity-raising capping broad market returns It also shows how dependent we remain on foreign capital to fund our growth If domestic investors continue to stay away from equity products foreign institutional investors will be the ones buying all this paper Investment banks in India at least still have a future irrespective of how they fare in the West for they will be the ones helping raise all this equityphr p ppThe writer is fund manager and CEO of Amansa Capitalp

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