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Sector update: Financials - Parliament approves expenditure for recap bonds; No MTM for recap bonds

The Parliament has approved the government’s request for additional spending of Rs800bn for recapitalisation of state owned banks through the issue of bonds:

• The recap bonds will be similar to those issued earlier. The government will issue these bonds to banks. The funds that the government raises from banks will be infused back into the banks as pure equity capital.
• This transaction is cash neutral for the banks.
• Banks will have to deploy the excess SLR to invest in the bonds. How the transaction will be structured is not known. But banks will have to generate cash to invest in these bonds. One option is that banks sell their excess SLR to RBI and redeploy it towards these bonds. We note that liquidity is running tight at the moment for banks in any case.
• For the government, the interest outgo on bonds will be part of fiscal deficit. We hear that the yield on bonds will be 7.5%. The total interest outgo will be close to Rs60bn.
• Earlier when the government has infused equity as part of the annual infusion plans, the allocation had been planned by SBI Caps on many occasions. This time round we believe only the FinMin and the RBI are involved. RBI had already announced in their previous credit policy that weaker banks will get the bear minimum solvency capital while stronger banks will get growth capital. So the allocation will favour stronger banks going by RBI statements who we believe has been working very closely towards the allocation of recap bonds this time round.
• Bank wise allocation is not yet out
• These bonds will be non-tradeable and non SLR. However, they will not have to be marked to market because according to RBI rules banks can hold recap bonds as HTM even if they are non SLR. The rule that HTM securities cannot exceed 20.5% of the NDTL still applies.
• Now that the Parliament has approved the recap expenditure, the issuance of bonds and bank wise allocation can be announced any time.

Below is the extract from the relevant RBI circular:

No fresh non-SLR securities, are permitted to be included in HTM, with effect from September 2, 2004 except the following:

1. a) Fresh re-capitalisation bonds received from the Government of India, towards their re-capitalisation requirement and held in their investment portfolio. This will not include re-capitalisation bonds of other banks acquired for investment purposes.
2. b) Fresh investment in the equity of subsidiaries and joint ventures.
3. c) RIDF / SIDBI/RHDF deposits.
4. d) Investment in long-term bonds (with a minimum residual maturity of seven years) issued by companies engaged in infrastructure activities.

Impact:  The PSU bank Index has corrected by 14% from the peak after the announcement of recap on October 24, 2017. The peak was on October 26, 2017 and YoY the PSU Bank Index is up 25%. After the initial euphoria, stocks of state banks have corrected because of changes to the NCLT which would lead to higher haircuts, a sharp rise in bond yields which could lead to MTM losses for state banks that have large bond portfolios and credit growth though picking up from lows still remaining unexciting. Liquidity has tightened which would lead to pressure on short term spreads. We still remain selective in buying state banks and continue to prefer private banks. SBI, BoB and PNB will likely outperform other state owned banks. HDFC Bank followed by ICICI Bank remains our top picks in the banking space.