This month’s capital injection into IDBI Bank indicates that Government remains unwilling to allow state banks to miss coupon payments on Additional Tier 1 (AT1) instruments, says Fitch Ratings.
“IDBI 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, said the rating agency in its report.
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.
The costs the Government faces in recapitalising state banks could potentially rise if access to the AT1 market weakens.
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.
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.
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.
IDBI itself reported substantial losses in the financial year ending March 2017 (FY17) and in its 1Q18 results. We had already downgraded the bank’s Viability Rating to ‘ccc’ from ‘bb-’ to reflect a sharp deterioration in its financial profile that had weakened core capitalisation close to minimum requirements.
Market pricing appears to assume that the government is likely to continue to ensure state banks do not miss coupon payments. 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.