The new Reserve Bank of India (RBI) guidelines for raising the regulatory capital through the preference shares route by scheduled commercial banks provides greater flexibility but is an expensive affair if it forms part of the Tier-I capital, rating agency, Icra said in a report.
Besides increasing the choices that the SCBs can exercise to reinforce their Tier-I and Tier-II capital, the guidelines also widen the latitude available to them for such capital reinforcement. However, the cost of raising capital works out to be higher with preference shares (which are a part of Tier-I) vis-?-vis other instruments like innovative perpetual debt (IPD), except equity.
If Indian SCBs were to utilise the full range of instruments (preference shares as well as the capital instruments allowed earlier), they would be able to maintain their capital adequacy at the March 31, 2007 levels of 12.3% while absorbing close to 180% growth in risk weighted assets (over March 31, 2007) in the next two years without resorting to equity funding.
It is thus evident that these instruments serve to substantially reduce the dependence of SCBs on the equity markets for capital expansion, the Icra report said. Moreover, if one were to factor in the large equity issuances by private banks and certain public sector banks in 2007-08 so far, the capacity of the SCBs, as a whole, to expand appears to be even higher.
Preference Shares, like the hybrid instruments (IPD and Upper Tier-II) introduced in January 2006, have greater risk-absorption capacity as compared with Lower Tier-II instruments and hence can have a beneficial impact on the issuing SCB?s economic capital. However, Indian SCBs are typically driven by regulatory capital norms while planning for capital and their focus on economic capital is still limited.
?Nevertheless, Icra expects the economic capital based approach to gradually gain ground, even as the implementation of advanced approaches under Basel II would narrow the gap between regulatory and economic capital further,?? the report said.
Besides this, cost considerations, maximisation of amount counted as capital and returns on equity and the limitations on raising equity play an important role in deciding the instrument for capital augmentation.
While perpetual non-cumulative preference shares (PNCPS), which can be used to reinforce Tier-I, provide SCBs with greater latitude in raising capital, substantial differences in the treatment of tax between such instruments and the hybrids, lower Tier-II and other preference shares could make PNCPS substantially expensive, Icra said.
This because the coupon payable on PNCPS will be treated as dividend and therefore subjected to dividend distribution tax (around 17% currently), even as the interest expenses incurred on other instruments are tax deductible.
But despite this disadvantage, certain public sector banks (PSBs) and a few private banks could issue such instruments to increase their Tier-I capital. Further, some banks may be able to use these instruments to optimise capital and thereby improve shareholder returns as preference shares for Tier-I may still work out cheaper than equity- the most expensive form of capital.
Going ahead, banks are expected to continue accessing external sources for capital augmentation, given that the capital requirement for organic growth is likely to exceed their internal capital generation.
