The Basel III Additional Tier 1 (AT1) issue of INR12.5bn by Bank of
India (BOI) on 28 July 2014 is a modest and slow beginning to the
significant need of such capital by Indian banks, says India Ratings
& Research (Ind-Ra). We estimate the requirement of AT1 capital in
FY15 and FY16 to reach INR544bn to meet Basel III's on-going capital
norms. Government banks account for 97% of this demand.
Investors have been concerned about any loss that this instrument may impose, particularly after the significant underperformance by a few government banks immediately after Basel III Tier II bonds were issued last year. The 11% coupon that newswires reported BOI paying for its AT1 bonds last week reflects this uncertainty; the coupon was about 175bp higher than ‘AAA' yields, implying a rating in the range of ‘A-'/‘BBB+'. The bank may have weighed this against the cost of equity estimated at around 15% for Indian banks, as also its somewhat weaker capitalisation compared with peers' (BOI's Basel III Tier 1 ratio of 7.24% at end-March 2014 was lower than the median 7.79% of government banks).
The underlying risk of these instruments must be more clearly explained to investors. Global market trends suggest that a pricing pattern for these bonds is still evolving. Investors seem to have ignored the ‘AAA' rating assigned by an agency to BOI's AT1 bonds, resulting in a distorted yield curve which works against the premise of an efficient bond market. This is a setback to the development of the local market.
It is, therefore, critical that a credible, transparent and matured rating benchmark be used for this instrument, which can then be factored in by investors while chalking out their investment guidelines. Till then, issuers may end up paying a premium for the uncertainty. For example, the pricing of the BOI paper may have been higher than what the underlying risk of the bank warranted.
While rating Tier 1 debt capital, Ind-Ra first evaluates the standalone credit profile of banks. The appropriate number of notches for these instruments is then decided depending on the loss absorption features of these instruments, the likelihood of these being triggered depending on the bank's credit profile (the non-performance risk) and the loss to investors in the event of non-performance (the loss severity).
Investors have been concerned about any loss that this instrument may impose, particularly after the significant underperformance by a few government banks immediately after Basel III Tier II bonds were issued last year. The 11% coupon that newswires reported BOI paying for its AT1 bonds last week reflects this uncertainty; the coupon was about 175bp higher than ‘AAA' yields, implying a rating in the range of ‘A-'/‘BBB+'. The bank may have weighed this against the cost of equity estimated at around 15% for Indian banks, as also its somewhat weaker capitalisation compared with peers' (BOI's Basel III Tier 1 ratio of 7.24% at end-March 2014 was lower than the median 7.79% of government banks).
The underlying risk of these instruments must be more clearly explained to investors. Global market trends suggest that a pricing pattern for these bonds is still evolving. Investors seem to have ignored the ‘AAA' rating assigned by an agency to BOI's AT1 bonds, resulting in a distorted yield curve which works against the premise of an efficient bond market. This is a setback to the development of the local market.
It is, therefore, critical that a credible, transparent and matured rating benchmark be used for this instrument, which can then be factored in by investors while chalking out their investment guidelines. Till then, issuers may end up paying a premium for the uncertainty. For example, the pricing of the BOI paper may have been higher than what the underlying risk of the bank warranted.
While rating Tier 1 debt capital, Ind-Ra first evaluates the standalone credit profile of banks. The appropriate number of notches for these instruments is then decided depending on the loss absorption features of these instruments, the likelihood of these being triggered depending on the bank's credit profile (the non-performance risk) and the loss to investors in the event of non-performance (the loss severity).
