A growing asset-liability mismatch in the Indian banking system and the need to ensure a steady flow of long-term capital for the infrastructure sector have pushed officials to consider reforms to the use of senior bonds as a bank funding tool, the people said.
Details of the measures are still under negotiation ahead of the July 10 Union Budget statement, but the discussions ongoing within the finance ministry underline the new government's determination to address the failings of India's banking system.
India's mostly state-owned lenders have shied away from issuing senior bonds in the local market simply because the Banking Regulation Act of 1949 does not explicitly allow banks to do so. Some banks have circumvented the rules by issuing senior debt overseas, but most lenders remain heavily reliant on deposits and short-term funding.
Almost half of all bank funding in the country matures in one year or less, according to analysts, while nearly 80% of the Indian banking sector's funding is held in deposits.
At the same time, Indian banks are heavily exposed to the infrastructure sector, typically through long-term loans. As of April this year, Indian bank lending to the infrastructure sector stood at Rs8.4trn, up 11% year-on-year and nearly 15% of all Indian credit.
Such a mismatch in maturities raises the risk of a systemic crisis should short-term funding markets seize up, as proved to be the case in the US in 2008.
It also complicates efforts to raise long-term funding for sorely needed infrastructure projects, and leaves developers exposed to varying interest charges that can have a big impact on running costs.
"Banks keep annual resets on project and corporate loans so that they can align their short-term funding costs with long-term liabilities," said a DCM banker. "Banks generally avoid raising long-term money at market rates."
Senior bonds are an established source of bank funding worldwide, and the potential for an Indian market is huge. Assuming restrictions are lifted, market participants believe Indian banks could issue at least Rs500bn-Rs600bn (US$8bn-$10bn) of senior bonds in the first year at tenors mainly of 10 to 30 years.
The government is expected to take a flexible approach to allowing senior bank bonds given the failure of a similar attempt in the past.
In June 2004, the Reserve Bank of India allowed banks to issue long-term bonds but attached a lot of conditions.
The RBI banned call and put options on these long-term bonds, and restricted the total amount of bond sales to no more than a bank's exposure to infrastructure loans with more than five years' residual maturity. Hardly any bank attempted such an issue.
The lack of senior bonds has also distorted risk pricing.
"As Indian banks do not issue senior bonds onshore, their subordinated bonds get priced like senior bonds," said Atul Joshi, CEO of India Ratings and Research, the local arm of Fitch.
"In 2004 when the RBI allowed long-term bonds of a minimum five years to be issued, the pricing of those bonds also automatically got linked to the bank's subordinated bonds, plus investors started asking for a premium for the infrastructure risk."
Indian investors see little difference between senior and subordinated bonds, an approach that has been reflected in the rating of these instruments. But Basel-III rules, which require subordinated bonds to carry loss-absorbing features, are challenging that approach, and analysts believe a pricing differential between senior and subordinated bonds will eventually open up.
Senior bonds should come at least 5bp-10bp tighter than the subordinated Basel II-compliant outstanding bonds from the same bank, Joshi said.
Other market participants said the spread between the senior and subordinated bank bonds might even go up to 50bp-100bp if a proper yield curve is established - as is the case in other, more developed markets elsewhere.
Privately owned lender ICICI Bank has made a few attempts to issue senior bonds onshore. In March 2013, the lender issued Rs11bn of 5.3-year senior bonds paying a coupon of 9.0%, 15bp-20bp tighter than its subordinated bonds at the time.
A flat-to-inverted rupee yield curve is likely to provide a further catalyst for long-term issues. At current benchmarks, an Indian company with a local Triple A rating can expect to raise 15-year money at a yield only 25bp higher than for one-year funding.
Modi's government has already approved a number of stalled infrastructure projects, and there is a strong case for banks to fix their asset-liability mismatches. The previous government set an ambitious infrastructure investment target of US$1trn in the five years ending 2017. Nearly half of this investment was to come from the private sector, including banks - split roughly into US$150bn of equity capital and about US$350bn of debt.