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Event update: Financials - Recap; Weaker banks get 59% of the first tranche

The government allocated the first tranche of the promised recapitalization package of Rs1.3trn which was announced in Oct. In the first tranche, Rs880bn will be allocated to state owned banks. Of this, 59% has been allocated to the eleven weaker banks where prompt corrective action (PCA) has been initiated while the rest has been allocated to nine stronger banks. No capital has been allocated to Indian Bank which is the strongest of the pack. So a large portion of the first tranche is towards regulatory capital and a smaller portion is towards growth. While recapitalizing the weaker banks should be the priority of any recap plan, the RBI and the government had made statements recently that a larger portion of the new capital will go towards growth. This has not happened. Weaker banks like IDBI, IOB, UCO and United have been allocated 50-100% of their existing market cap while SBI’s allocation is a low 3% of mcap. SBI’s share of allocation is lower than its share in the last two allocations. The logic behind the allocation would be that the stronger banks have already raised or are close to raising funds through QIPs, hence more allocation to the weaker banks.

Recommendation: The short term reaction will be a rally in some of the weaker banks specially IDBI Bank, Bank of India and Central Bank of India. These banks have received a higher share of the allocation and dilution to BVPS here will be lower than other weaker banks. The capital allocation announcement is negative for SBI as it has received the lowest share since Indradhanush was launched. It is neutral for PNB and BoB. Now that the capital allocation is announced the focus will be on earnings and stress asset resolution. We expect earnings of state owned banks to be weak over the next few quarters led by higher bad loan provisions and higher trading / MTM losses. Also, banks will have to recognize some lumpy accounts as NPLs including RCOM, Aircel, Videocon International. We see the highest earnings risk for SBI.

Key gainers from the allocation: The key gainers from the allocation are the banks that have got a higher share of the allocation and yet will see lower dilutions and stronger CET-1 ratios. IDBI, BoI, Central and UCO are banks that fit into this. We note that while CET 1 ratios of some banks like UCO look very strong after factoring in capital infusion, they may have already identified bad loans to recognise against the new capital. A detailed table of post infusion BVPS and CET1 is on the following page.

Structure of infusion: Capital allocation will be cash neutral. The tenor of bonds will be 10-15 years. These will be issued at a spread to the relevant G-secs. They are likely to be priced at around 8% according to a TOI report. These will be non-SLR bonds. However, banks will not be required to mark these to market because of an existing RBI regulation which exempts non-SLR bonds that are issued for the purpose of recap from being marked to market. The method of recap will be the same as done previously which is 1) The government will issue recap bonds to banks at a spread over gsec. These bonds will be non SLR investments for banks. Banks will earn a coupon on these bonds 2) The funds that the government gets from these bonds will be infused back into the banks as equity capital.

Sources of funds: Of the total allocation of Rs881bn, Rs800bn will come through recap bonds and the remaining Rs81bn will come through budgetary allocation under Indradhanush.

MSME lending to be a key focus: The recap package will create incremental lending capacity of Rs5 trillion according to the FinMin, a large portion of which should be used towards MSME lending. We believe banks still don’t have robust systems to control NPLs in the MSME segment.

Capital comes with reforms: Along with the capital allocation, the government has laid out reforms that banks are expected to undertake. The government has listed a six-fold roadmap for banking reforms in the country which will facilitate ease of banking and encourage clean business. The government has also promised that there will be no government interference in lending decisions. Key reforms: To be part of a loan consortium, banks will need to commit at least 10 percent of the total amount. All loans above Rs 2.5bn will invite specialized monitoring. If any of the covenants decided upon at the time of a loan sanction are breached, that will be considered a red flag and shared across the consortium of lenders. There will be a separate stressed asset vertical in each of bank for cleaner and timely recovery. The government has also asked all banks to identify non-core assets for monetisation and rationalize overseas operation. In addition, each bank has been asked to identify its core strengths and focus on those rather than becoming ‘me-too’ lenders.