Indian banks’ additional Tier I requirement for 5 years to zoom to Rs200 bn, presenting significant risk to investors: ICRA

With the capital requirement of Indian banks likely to go up gradually till 2018-19 (FY2019), Tier I issuances (common equity + additional tier I) are likely to increase significantly till that year.

As Chart 1 brings out, while the AT1 additional tier 1 (or AT1) requirement for this fiscal year (FY2015) would be around Rs200 billion, in subsequent years, the annual requirement could be as high as Rs400 – 500 billion.

Note: Amounts in Rs. Billion: Source: Banks Reports, ICRA Research

However, these instruments come with significant risk. The guidelines of the Reserve Bank of India (RBI) on Basel III introduce stringent loss absorption clauses for hybrid instruments so that loss absorption kicks in before the ''public injection of funds''.

While both Tier I and Tier II instruments have significant loss absorption features, Tier I instruments are meant to absorb losses on a going concern basis, and therefore, the loss absorption trigger kicks in fairly early. The high loss absorption features of Tier I is likely to bail out depositors as well as investors in Tier II instruments well ahead of stress. The triggers for Tier II instruments, which also have loss absorption features, are meant to be invoked at the ''point of non-viability'' (PONV), and therefore, are likely to protect depositors and senior lenders on a gone concern basis.

Source: RBI

The risk of default and severity of loss are both significantly higher for AT1 instruments than for deposits or the senior debt of the issuing bank.

This is so because AT1 investors may have to absorb losses on a going concern basis to protect depositors and are not expected to be bailed out by the government. Default on AT1 could be triggered by the breach of the capital conservation buffer (less than 2.5 per cent), breach of the CET1 threshold (less than 5.5 per cent), at the ''point of non-viability'' (PONV) and in the event of loss. Since the probability of hitting these thresholds is significantly higher than the likelihood of hitting the default threshold for senior debt, the default probability for AT1 is also correspondingly higher.

In the case of conventional debt instruments, depositors (as well as other senior debt holders) benefit from strong government support to banks because of their systemic importance.

Besides, since most banks in India are government owned, strong support from the government. as owner of the banks, in case of stress could also cushion them against the losses. It is because of such strong support that no scheduled commercial bank has defaulted in the past even as some have reported losses or have been in breach of minimum capital adequacy norms. Further, there have been instances in which weak banks have been merged with stronger ones at the government's instructions to protect depositors.

While strong governmental support reduces the probability of liquidation for a bank, what adds to the comfort is that even on liquidation, deposits of up to Rs. 1 lakh individually are covered under the deposit insurance scheme of the Deposit Insurance and Credit Guarantee Corporation of India (DICGC). This reduces the severity of loss for depositors in the event of liquidation of a bank.

Thus, senior debt holders and depositors are likely to face a loss only when a bank has significant asset-liability mismatches or it undergoes liquidation. This would happen when the entire equity of the bank is wiped out despite infusion of funds by the Government and AT1 as well as Tier II bonds are written off or permanently converted into equity.

As for credit rating of these instruments, given the high level of risks associated with AT1 instruments as discussed, it is highly unlikely that AT1 would be rated at the same level as deposits or senior debt issued by the same bank. International rating agencies rate AT1 instruments at least three notches lower than the senior debt.