ICRA Rating Feature

February 2006

Introduction of new capital instruments: Indian banks

get greater latitude to raise capital

On the face of it there has been no significant change in the reported

Contacts: capital adequacy (capital as a percentage of risk-weighted assets) of
Indian scheduled commercial banks (SCBs) since March 31, 20031.
Vineet Gupta
vineet@icraindia.com However, if one were to look at the underlying risk-weighted assets
+91-22-2433 1046/53/62
and capital, these have undergone significant changes post-March 31,
Vibha Batra 2003. While the risk-weighted assets of SCBs have grown by almost
vibha@icraindia.com
+91-11-23357940-50 55% during the period stated, a similar increase in capital has allowed
them to maintain stability on the capital adequacy front. Going
forward, given the significant credit growth and regulatory changes
expected, the Indian banking system’s appetite for capital is likely to
increase over the medium term, when the avenues of the past for
capital-base expansion may show up as inadequate. Anticipating this
likely scenario, the Reserve Bank of India (RBI) has, in line with the
Basel II guidelines and international experience, introduced certain
regulatory changes in 2005-06 so as to provide greater latitude to
Indian SCBs to reinforce their capital base. This paper tries to look at
how the Indian banking system has fared on the capital adequacy
front in the past and at the ways available to them to expand their
capital base, going forward.

Website:
www.icraratings.com
www.icra.in

1
Their Capital Adequacy Ratio has moved up marginally from 12.7% as on
March 31, 2003 to 12.8% as on March 31, 2005
 ICRA Rating Feature Introduction of new capital instruments by RBI

Risk-weighted assets increase significantly, but regulatory capital adequacy

remains stable
While SCBs reported moderate growth in their risk-
weighted assets and capital in 2003-04, the following Movement in Capital Adequacy of
fiscal (2004-05) saw a marked increase of around 40% Indian SCBs
year-on-year (yoy) in their risk-weighted assets. Despite Chart 1
this however, in 2004-05, the banking system was able to
maintain a capital to risk weighted assets ratio (CRAR)
15.00%
that was almost similar to that reported in the previous
12.00%
year. This was the outcome of a substantial expansion in
capital base (especially Tier 1 capital), which matched 9.00%
pace with the growth in risk weighted assets. While 6.00%
internal capital generation and equity issues helped SCBs 3.00%
grow their Tier 1 capital in 2004-05, the increase in their Mar-03 Mar-04 Mar-05
Tier 2 capital was facilitated by a rise of 30% in
subordinated debt and of 15% in their Investment
Fluctuation Reserve (IFR).

Table 1: Increase in risk-weighted assets of Indian Scheduled Commercial Banks vis-à-vis capital
April 2003– April 2004–
March 2004 March 2005
% Increase in Capital
Tier 1 10% 39%
Tier 2 31% 22%
Total Capital 17% 32%
% increase in Risk-weighted Assets
(RWA)
RWA: Credit 17% 39%
RWA: Others 11% 22%
Total RWA 15% 34%
Source of base data: “Report on Trend and Progress of Banking in India, 2004-05”, RBI

In 2004-05, various regulatory changes brought in by the RBI resulted in the risk-weighted assets of SCBs
increasing by a higher 40% (yoy) for advances vis-à-vis 28% for their advances portfolio. The major regulatory
changes that increased the RWAs on the credit side included:

ƒ increase in risk weight for consumer loans from 100% to 125%,

ƒ increase in risk weight for home loans from 50% to 75%, and
ƒ increase in risk weight for loans to Public Financial Institutions from 20% to 100% for credit risk.

Further, the requirement of market risk allocation for the “held for trading” portfolio is also likely to have contributed
towards the increase in the risk-weighted assets of SCBs in 2004-05.

The road ahead

With the adoption of Basel II guidelines, the rate of increase of risk-weighted assets on the credit side is broadly
estimated to be marginally lower than the pace of credit growth as some capital gets released following the
implementation of the standardised approach2. This however is likely to be more than offset by the requirement of
additional allocation for market risk3 and operational risk4, which together are expected to add significantly to the
risk-weighted assets of Indian SCBs over the medium term. Moreover, the RBI’s guidelines on Capital Treatment
for securitisation deals are likely to add further to the requirement of additional capital, although the impact of this
regulation may not be very significant for the system as a whole, given the relatively small size of the domestic
securitisation market. According to ICRA, growth in the risk-weighted assets of SCBs is likely to be quite
pronounced in the coming two years on account of the regulatory changes. Thereafter, the pace is likely to drop to
moderate levels, following a similar trajectory as the rate of business growth. While the regulatory changes

2
as the capital allocation would be based on credit risk profile
3
on the “available-for-sale” portfolio from 2005-06 onwards
4
from 2006-07 onwards
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ICRA Rating Feature Introduction of new capital instruments by RBI

discussed would lead to capital better reflecting risk, SCBs would also have to reinforce their capital base
significantly.

Considering the current buoyancy in the business environment and the strong growth in retail credit, overall credit
offtake for SCBs is likely to remain strong over the medium term. The expectation is corroborated by the over 30%
yoy growth in SCBs ’ non-food credit till end-January, 2006. On the whole, ICRA expects growth in SCBs ’ credit
related risk-weighted assets to be in the range of 55-65% over the next two years. Market risk and operational risk
are expected to contribute to increasing the risk-weighted assets by 15-20% over the March 31, 2005 levels
during the same period. Thus, risk-weighted assets of SCBs could grow by 70-85% over the next two years,
before getting aligned to the business growth rate subsequently.

Now, if one were to assume no change in capital vis-à-vis the March 31, 2005 levels, the capital adequacy of
SCBs would drop sharply to 7-7.5% by March 31, 2007. Ergo, the rush of scheduled commercial SCBs to
reinforce their capital base.

In the current financial year (2005-06), it is

estimated that SCBs would be raising Rs. Expected Movement in Capital adequacy of Indian SCBs
160 billion through equity and around Rs. ( assuming no external capital augmentation of estimated Capital
180 billion through subordinated debt beyond March 31, 2006)
issues. Put together, the sum would be Chart 2
adequate to cover 20% growth without
dilution in capital adequacy. Despite this
however, over the medium to long term, 15.00%
the high growth expected in the risk- 12.00%
weighted assets of SCBs could lead to a 9.00% Tier 2 capital
significant reduction in capital adequacy if 6.00% Tier 1 capital
SCBs were to rely merely on internal 3.00%
capital generation. According to ICRA’s 0.00%
estimates, the capital adequacy of Mar- Mar- Mar- Mar- Mar- Mar- Mar- Mar-
scheduled commercial SCBs could fall
below the regulatory 9% by March 2009 in
03 04 05 06 07 08 09 10
the absence of external capital support.

New capital instruments: increasing the options to raise capital

Till recently, apart from internal generation, the only options available to Indian SCBs to shore up their capital
were equity issues and subordinated debt. This could have been a limiting factor, especially for public sector
banks5 (PSBs) and even for the rapidly-growing private banks. The recent regulatory changes provide more
flexibility to SCBs to achieve superior Tier 1, besides offering significantly greater latitude for the raising of Tier 2
capital.

ƒ Inclusion of IFR in Tier 1 from March 31, 20066: This will increase Tier 1 capital by around 20% over the
March 31, 2005 levels and provide greater latitude for the raising of Tier 2 capital.
ƒ Introduction of Innovative Perpetual Debt Instrument: This would increase the leeway for Tier 1 by 21%
(17.65%7 on account of old Tier 1 and around 3.5% on account of the IFR inclusion in Tier 1) and effect a
corresponding increase in the scope for enhancing Tier 2 as well.
ƒ Introduction of Senior Subordinated debt: This would lead a significant increase in the ability of SCBs to
increase Tier 2 since the subordinated debt component is now restricted to 50% of the total Tier 1 capital
while the overall Tier 2 component can go up to 100% of Tier 1. So far, while SCBs utilised headroom for
subordinated debt to the extent of around 48%, the utilization was only close to 16% for the other component
(Tier 1 minus Subordinated debt) as the components eligible under this were limited. Although the increase in
credit provisions for standard assets would increase utilisation of this part marginally, the new instrument
would allow SCBs to close this gap.

5
for them, the scope to raise capital via equity issue is limited by the fact that Government’s holding in the PSBs is
already close to 51%
6
till March 31, 2005 IFR was part of Tier 2
7
According to Basel II norms, innovative perpetual debt should not exceed 15% of Tier 1, i.e. Innovative Tier 1 can be
raised up to (15%/85% = 17.65%) of Old Tier 1, gross of any deductions (barring goodwill). However, ICRA has taken
Net Tier 1 as the base for computations as there is lack of clarity on this issue, according to the RBI circular of January
2006 Year. However, if Gross Tier 1 were to be taken as the base, the ceiling would be higher at 20% of old Tier 1
(compared with 17.65%).

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ICRA Rating Feature Introduction of new capital instruments by RBI

The combined impact of these regulatory changes has been computed in Table 2.

Table 2: Capital markets and regulatory changes in 2005-06 increase the latitude available to SCBs to
augment capital
Basis of Computation of Latitude
for Capital Raising
As on
March 31, 2005 March 31, Subordinated
March 31, Innovative Upper
(with IFR as part 2006 Bonds (Old
2005 Tier 1 Tier 2
of Tier 1) (estimated) Tier 2)
(actual)
Tier 1
Gross Tier 1 1,240 1,240 8 8 8
Less Deductions 150 150 8 8 8
A1 Net Tier 1 1,089 1,089 8 8 8
A2 IFR - 217 8 8 8
A= 17.65% of 50% of
Total Tier 1 1,089 1,307 1,631 50% of A
A1+A2 A A

Tier 2
Reduce leeway
by the amount
B1 Tier 2 Bonds 263 263 443 8 8
already raised
(-B1)
B2 IFR 217 - 8 8 8
Reduce
leeway
by the
extent of
B3 Other Tier 2 90 90 110 8 8
the other
Tier 2
compone
nt (-B3)
B Total Tier 2 570 352 553 8 8 8
A+B Tier 1 + Tier 2 1,659 1,659 2,184 - - -
C
Leeway for
=17.65% 8 50% of C 50% of C
Innovative Tier 1
of A
Source of base data: “Report on Trend and Progress of Banking in India, 2004-05”, RBI

Please refer Annexure for a comparison on the features of the new instruments mentioned in Table 2.

Using the base numbers worked out in Table 2, the extent by which SCBs may increase their capital is brought
out in Table 3.

Table 3: Increase in leeway to raise capital

8
Total Leeway Innovative Upper Tier Subordinated Total Leeway Increase in
As on As per the Tier 1 2 Bonds ( Old Tier leeway over
2) original March
31, 2005
levels
Mar-05 Extant regulations 282 282
Mar-05 Regulatory changes 231 679 506 1,415 403%
introduced in 2005-06
Mar-06 Infusion of capital + 288 850 517 1,654 488%
regulatory changes

As Table 3 shows, SCBs had limited options to boost capital till March 2005. Given the guidelines then, the
leeway available to them would have been adequate to support just about 17% growth in their risk-weighted
assets without any change in capital adequacy. However, equity issues and major regulatory changes during
2005-06 have given SCBs significant space for raising external capital, with the Upper Tier 2 increasing the

8
excluding equity issuances

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ICRA Rating Feature Introduction of new capital instruments by RBI

latitude considerably. Noticeably, around 17% of the leeway available to the SCBs now is in form of superior Tier
1 Capital. The increase in capital would help SCBs achieve a sharp increase in their risk-weighted assets at
different capital adequacy levels, as brought out in Table 4.

Table 4: Permissible increase in risk-weighted assets over the estimated March 31, 2006 level9

At Capital Adequacy Scenario 1 Scenario 2 Scenario 3

Level
Only Subordinated Debt Innovative Tier 1 Innovative Tier 1 + Subordinated
+ Subordinated bonds + Upper Tier 2
bonds
13.50% 6% 18% 53%
12.80%10 18% 30% 67%
12.00% 32% 45% 78%
11.00% 52% 68% 78%

As is evident from Table 4, the banking system as a whole can augment its capital base using the new
instruments to absorb the significant likely growth in risk-weighted assets while maintaining capital adequacy well
above the regulatory minimum.

Success of new instruments hinges on investor diversity, capital adequacy

pressures
The new instruments, which combine the features of debt (regular interest payments, for instance) and equity-like
characteristics (such as long/perpetual maturities and provision to defer payments) are yet to be tested in the
Indian market. Moreover, developing a diverse investor base for these long-maturity instruments would be no
small challenge. As of now, banks appear to be the largest potential investors, but if they prove to be so, the
cross-holdings11 among banks could have the result of increasing the capital levels of individual banks even as the
capital level of the banking system as a whole remains static. Clearly, this would contradict the spirit of the Basel
Accord.
Further, while the equity-like characteristics of the new instruments make them eligible for inclusion in capital, it is
these very features that would force issuers to pay a premium over normal subordinated debt. Thus, scheduled
commercial banks may first seek to exhaust the existing options for capital raising (which may work out cheaper)
and only then go in for the new instruments. This in turn could result in the market remaining thin for the new
instruments, at least in the short term. However, while the premium may act as some sort of a deterrent, the
pressure on capital adequacy may prove to be the overriding factor, prompting individual banks to opt for the new
instruments.

9
subject to the condition that Tier 1 does not go below 6%
10
Capital Adequacy of scheduled commercial banks in India as on March 31, 2005
11
restricted to 10% of the total capital of a bank

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ICRA Rating Feature
Annexure
Comparison amongst the features of various debt instruments
Innovative Tier 1
Nature of Capital Tier 1 capital
Prior Approval from Required only in case of
RBI foreign currency issuance
15% of Tier 1; rest can be
Limit included in Tier 2 up to the
ceiling
Superior to claims of
Seniority of Claims
investors in equity shares
Maturity Perpetual
No put option. Call option
Put/Call option only after 10 years, subject
to RBI approval
Non-cumulative interest;
need not be paid if CRAR
falls/likely to fall below
Debt Servicing minimum regulatory
requirement, but can be
paid, subject to RBI approval
in a loss situation
Market determined rupee
Rate of interest
interest benchmark rate
Up to 100 basis points from
initial rate; allowed once
Step up option during life of instrument to be
used in conjunction with the
call option
Discount None
ƒ Investment by Foreign
Institutional Investors
(FIIs) & Non-Resident
Indians (NRIs), subject
to 49% & 24% limit
respectively, with
Investors
individual ceilings of
10% & 5% respectively.
ƒ Banks can hold the
instrument, subject to a
ceiling of 10% of total
capital
Attracts Cash Reserve Ratio
Reserve Required (CRR) / Statutory Liquidity
Reserve (SLR)
Risk Weight (Investor
100%
Bank)
Grant of advances
against the security of Not Allowed
instrument
ICRA Rating Services
Introduction of new capital instruments by RBI
Subordinated Bonds (Old
Upper Tier 2
Tier 2)
Upper Tier 2 capital Tier 2 capital
Required only in case of Not required (requirement
foreign currency issuance only for foreign banks)
100% of Tier 1 along with
50% of Tier 1
other components
Superior to claims of
investors in equity shares and Subordinate to claims of other
investors in instruments creditors
eligible for Tier 1
Minimum 15 years Minimum 5 years
No put option. Call option only
after 10 years, subject to RBI No option allowed
approval
Not liable to pay either
interest or principal if CRAR
falls/likely to fall below
minimum regulatory
requirement. However, debt
servicing possible, subject to No such restriction
RBI approval in a loss
situation. Interest can be
accumulated and Interest and
principal can be paid once the
conditions are met.
Market determined rupee G SEC (of similar maturity) +
interest benchmark rate 200 basis points
Up to 100 basis points from
initial rate; allowed once
during life of instrument to be Not available
used in conjunction with the
call option
Rate of Rate of
Remaining Remaining
discount discount
maturity maturity
(%) (%)
< 1 yr. 100 < 1 yr. 100
> 1 yr but < 2 yrs 80 > 1yr but < 2 yrs 80
> 2 yrs but < 3 yrs 60 > 2 yrs but < 3 yrs 60
> 3 yrs but < 4 yrs 40 > 3 yrs but < 4 yrs 40
> 4 yrs but < 5 yrs. 20 > 4 yrs but < 5 yrs 20
ƒ Investment by FIIs &
NRIs, subject to 49% &
ƒ As per existing FII
24% limit respectively,
investment limit
with individual ceilings of
ƒ Banks can hold the
10% & 5% respectively.
instrument, subject to a
ƒ Banks can hold the
ceiling of 10% of total
instrument, subject to a
capital
ceiling of 10% of total
capital
Attracts CRR/SLR reserve Attracts CRR/SLR reserve
100% 100%
Not Allowed Not Allowed
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ICRA Rating Feature Introduction of new capital instruments by RBI

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