- By Sameer Kaul
The primary purpose of a bank is to engage in the business of banking, which entails taking deposits and giving loans. For engaging in this business, banks are required to have sufficient capital, such that their deposit holders are protected. The capital required by banks is regulated by The Reserve Bank of India, which is the primary regulator for all banking activities in India. Internationally, central bankers like RBI follow common minimum standards of capital adequacy, which are known as the Basel accords. Post the Global Financial Crisis in 2008, regulators around the world agreed to stronger capital adequacy norms, to protect banks from any systemic risk and keep adequate capital buffers. These regulations are known as Basel III regulations and banks in India are following these guidelines since the past few years. In fact, Indian regulations are more conservative, insomuch as the minimum Capital Adequacy for banks in India is 1% more than that required under Basel III.
Under the Based III framework, banks’ regulatory capital is divided into Tier 1 and Tier 2 capital. Tier 1 capital is subdivided into Common Equity (CET) and Additional Capital (AT1). In simple terms, equity and preference capital is classified as CET and perpetual bonds are classified as AT1. Together, CET and AT1 are called Common Equity. Under Basel III norms, minimum requirement for Common Equity Capital has been defined. By nature, CET is the equity capital of the bank, where returns are linked to the banks’ performance and therefore the performance of the share price. However, AT1 bonds are in the nature of debt instruments, which carry a fixed coupon payable annually from past or present profits of the bank. These AT1 bonds have no maturity and are therefore called perpetual bonds. However, normally these bonds have a “call feature”, which enables the bank to recall these bonds at the end of five years. Tier 2 capital consists of subordinated debt with an original maturity of at least five years. Both AT1 and Tier 2 capital are subordinated debt instruments and are ranked lower than deposits, secured and unsecured creditors in the order of liquidation. Tier 1 capital ordinarily ranks higher than common equity holders
Apart from the tenor, the other key feature of AT1 bonds is that these instruments have principal loss absorption feature at an objective pre-specified trigger point through either (i) conversion into common shares or (ii) a write-down mechanism which allocates losses to these instruments. The loss absorption through conversion / write-down of AT 1 instruments is triggered when CET falls below a pre-determined threshold of Risk Weighted Assets (RWAs). When this trigger is activated, the RBI can direct the bank to take necessary action as per the severity of the issue, which could mean write off, conversion into equity or both.
The RBI has also added an additional trigger in Indian regulations, called the ‘Point of Non-Viability Trigger’ (PONV). In a situation where a bank faces severe losses leading to erosion of regulatory capital, the RBI can decide if the bank has reached a situation wherein it is no longer viable.The RBI can then activate a PONV trigger and assume executive powers. By doing so, the RBI can do whatever is required to get the bank on track, including superseding the existing management, forcing the bank to raise additional capital and so on. However, activating PONV is followed by a write down of the AT1 bonds, as determined by the RBI. These are covered in detail under sections 44 and 45 of the Banking Regulation Act, 1949.
In the case of Yes Bank, the Reserve Bank of India has decided to supersede the Board of the Bank and has presented a Draft ‘Yes Bank Ltd. Reconstruction Scheme, 2020’ under section 45 of the BR Act, 1949. As a part of this proposal the RBI has proposed to permanently write off the AT1 bonds issued by the bank while protecting the interest of the depositors. Such a proposal ends up affecting retail investors who may have invested in the AT1 bonds directly. It also impacts investors who have invested in Mutual Fundswhich in turn have invested in these instruments. As on date 32 mutual fund schemes have invested in the AT1 bonds of Yes Bank.Additionally, some insurance companies have also invested in these bonds, which also impacts policy holders’ interest. Therefore the ramifications of this write down is severe and it will end up impacting a large number of retail investors who have either directly, or indirectly invested in these AT1 bonds issued by Yes Bank.
Given that one of the important objectives of the regulator is to protect retail investors, a solution has to be found which will protect the interests of these investors. One of the possible solutions that the regulation allows for is to convert the debt into equity. This conversion allows the bank to write off their liability, can offset the higher permanent capital against provisions for bad loans and still give the bond holders the chance to participate in the future success of the bank and recover their lost dues. A permanent write down, while within the regulatory ambit, changes the risk characteristics of this instrument and my end up damaging the AT1 market in India permanently.
The bond market in India has faced multiple challenges in the last few years, starting from the IL&FS crisis. This crisis is fully manifested in debt mutual funds, which have performed poorly and, in many cases, also eroded investor capital. Indian investors have traditionally looked at debt mutual funds as a safe investment and were accustomed to a regular return on this investment. The last few years have shaken that belief, and this event can potentially shatter the residual semblance of belief in debt funds. This will set back the development of the corporate bond market in India by a few more years.
- Sameer Kaul is MD and CEO, TrustPlutus wealth management services. Views expressed are the author’s own.