Banks : Where is capital consumption in public banks? : Deep dive into capital consumption and requirements - Kotak

Where is capital consumption in public banks? Overall tier-1 ratio improved by ~30bps yoy to 9.7% but core tier-1 ratio was broadly flat yoy at 8.8% of loans. Interestingly, despite NPLs increasing 55% since FY2015, RWA growth was muted at 2%. Public banks received a capital infusion of US$~4bn in FY2017 mostly from the Government. They need ~US$ 7bn to meet their regulatory requirements of Basel 3. Private banks have adequate headroom to improve market share in the interim. BoB and SBI are well positioned among public banks.

Capital infusion, low RWA growth and AT-1 issuances drive marginal improvement in Tier-1.

PSU banks in aggregate have seen ~30 bps improvement in Tier-1 ratio to 9.7%, even as capital infusion by GoI and LIC (~45 bps of RWA) was offset by losses in a few banks, resulting in unchanged CET-1 (i.e. common equity) ratio at 8.8%. Efficient capital utilization led to RWA growth falling further to 3% yoy. We maintain our view on subdued RWA growth, reflecting anemic growth in private sector capital expenditure. High losses have resulted in negligible dividend payout for public banks.

RWA growth at 2% yoy is partly addressed by slower loan growth of 2%

Public banks appear to have pulled back lending in the past few years as a means to conserve capital. Loan growth was slower at 2% CAGR in the past two years, but RWA growth should have been higher as NPLs, which carry 150% RWA, increased 55% CAGR and ~40% CAGR in the past five years. The underlying demand is not particularly great, but it does appear that public banks, which dominate banking, have possibly put a standstill clause to any fresh demand for funds. This remains a good time for private banks to gain market share in the medium-term as they enjoy comfortable capital position.

Tweaking capital requirements to factor capital infusion; slow growth appears to be by design

Since FY2010, total capital infusion, excluding conversion of preference shares, was US$22 bn. We estimate another US$ 7 bn would be sufficient to maintain 9% tier-1 ratio for public banks. We maintain our view that public banks would continue to maintain limited cushion over tier-1 regulatory requirements given their nature of ownership. Our estimates, though aggressive, rest on two arguments-(1) slow demand revival in the investment climate and (2) our assumptions currently factor in high credit costs and low growth. Our hypothesis rests on the assumption that loan growth is not likely to be an independent event and would coincide with a decline in credit costs and improving RoEs. We remain less convinced on counter-cyclical buffer coming into effect any time soon and believe that banks have a fairly comfortable period to comply with D-SIB regulations, at least the frontline banks. Public banks are likely to generate US$23 bn of operating profit in FY2018 which should help them offset higher credit costs.

Leverage ratio is becoming a bigger challenge than meeting headline capital ratios

We are a bit more concerned on the leverage ratio than CAR. RBI has recommended an upper cap of 4.5% (22X) and we see shortfalls in quite a few banks. The overall (on-balance sheet) leverage has been fairly stable at 19X but there are over 10 banks where the ratio has crossed 20X. The off-balance sheet in most public banks is fairly low and hence the risk is driven by loans. These banks need to see RoE improvement, capital dilution and slow growth.

Tier-1 ratio improves for public banks as RWA growth slows down to 3% for

Overall CAR for PSU banks improved by ~20 bps yoy to 12.3% at end FY2017. This is driven by ~30 bps improvement in AT-1 capital to ~90 bps, while the core equity CET-1 was stable yoy at 8.8% and Tier-2 capital declined ~10 bps yoy to 2.6%.

CET-1 was stable yoy despite ~40 bps capital infusion by GoI which was along expected lines at ~Rs250 bn as losses at a few large banks (BOI, IOB, OBC) led to capital erosion in FY2017. Some banks like the Indian Bank, SBI, BOI and Canara Bank have high CARs of ~13% or more. IDBI Bank, IOB, UCO Bank and Dena Bank are among the weaker banks.

PSU banks have slowed down RWA growth to ~3% yoy compared to 5% in FY2016. Select banks IOB (13% yoy), CBOI (12% yoy decline), IDBI Bank (9% yoy) and UCO Bank (8% yoy) have aggressively slowed down RWA growth with 8 out of 21 banks reporting RWA decline. This improvement has come at a time when banks have faced fairly large disappointments in impairment ratios which technically leads to higher RWA growth. We believe that PSU banks have been partly forced to slow down lending as the opportunity to grow in the corporate sector has significantly slowed in recent quarters as the investment cycle is fairly weak at this stage.

Capital adequacy - 2019 targets: Ind-AS adds another level of uncertainty

The transition requirements of Basel-3 for Indian Banks. Banks need to maintain minimum regulatory capital of 10.25% at end FY2017, 10.88% by FY2018 and 11.5% by FY2019. Most banks are comfortably placed to comply with the 11.5% requirement. Given that full compliance is still a few years away, we do believe that transition would be fairly smooth for Indian banks. We are yet to fully understand the impact of Ind-AS as the impact of expected loss remains a big area of uncertainty.

D-SIB requirements for SBI and ICICI Bank are gradual and manageable

RBI has notified that SBI and ICICI Bank are the D-SIBs in India SBI would need to maintain additional capital in the form of common equity tier-1 of 60bps and ICICI Bank 20bps. Both these banks are well capitalized currently and we do not see them having any problems on meeting this regulatory requirement. The time frame for full implementation of D-SIB is comfortable as they only need to be complied with by April 01, 2019. Till then, there would be phased implementation. SBI would see a gradual increase of 15bps each year and ICICI Bank 5bps. Given SBI's tier-1 ratio at ~10% and ICICI Bank's at ~12%, we do not see any immediate impact from the guidelines announced today.

These banks (size, based on Basel-3, would be at least 2% of GDP) would be identified annually (beginning August 2015) and have a graded capital structure based on (a) size (b) inter-connectedness (c) substitutability and (d) complexity. Size would have the maximum weightage at 40% and the balance would be 20% each.

Slow growth partly reduces the requirements of higher capital infusion

As per our bottom-up analysis, public banks would need capital infusion of US$7 bn over FY2017-19E. We have reduced the estimate from our last year's projection of US$12 bn over FY2016-18E post the recent capital infusion and relaxations in tier-1 ratio.

Note that this is a simple model which factors RWA growth at ~7-10% for the medium term. If growth were to change materially over the next few years, then capital calls would be higher. However, we do believe that our RoE partly captures this growth. Our assumptions on RoEs are fairly subdued at 10-12% across banks. This is primarily because we expect public banks to have fairly high credit costs during this period as they continue to resolve the stress in their underlying loan portfolio. However, our belief is that growth and RoEs in these banks would not be independent events given that they tend to focus on the corporate segment. We believe if growth were to return, then banks could also see a decline in credit costs and improve revenue profile which would result in better RoEs and give them adequate headroom to disburse fresh demand of credit, if needed.

We note that most public banks have been asking for a higher share of capital infusion from GoI as there is a belief that capital is becoming a constraint to take decisions on lending. However, we are not too sure of the same as we believe that the demand for loans from the corporate sector would be fairly weak as most companies are heavily leveraged and looking at mediums to improve coverage ratios. Hence, at this stage, we are not too certain of a revival in private capital expenditure which implies asset heavy business that banks need for strong loan growth would be fairly subdued. Also, we note that we have gone through a fairly long period of an increase in working capital cycle part of which was led by inflation and the other led by a slowdown in the economy. We believe that an improvement in economy would also result in an improvement in working capital cycles leading to lower demand in the initial leg of the cycle. We do see a few banks looking to reduce their balance sheet in the medium term as they address impairment related issues.

We don't see any immediate requirements for private banks to raise capital though we see most of these banks maintaining much higher capital than regulatory requirement.

We have calculated capital requirements for banks to meet a minimum tier-1 ratio of 9% (5.5% common and 2.5% CCB). However, recent guidelines by RBI on the need to build capital conservation buffer and higher capital requirement for systematically important banks would require large banks to maintain almost 11% as tier-1, core equity of 8%, CCB requirement of 1.2-1.4%, additional 0.8% for D-SIB and cushion to grow over the regulatory requirement of 1-1.5%. Capital requirement would therefore be much higher when these guidelines are implemented.

The capital requirement is ~10% of current market capitalization at an aggregate level for public banks (15% ex-BOB and SBI). However, at an individual level, the requirement is over 20-40% for several banks. UCO, BoMh, OBC and IOB would be the worst placed with a capital requirement of almost 30-90% of current market capitalization.

GOI and LIC shareholding more than 80% in select public banks; a need to diversify shareholding base

GOI's shareholding has increased in 13 out of 21 PSU banks we have tracked and has remained unchanged in the rest, whereas LIC's shareholding has declined in most banks. United bank (85%), Bank of Maharashtra (82%), Central Bank (81%), and Punjab Sind Bank (80%) had high GOI stakes at end FY2017. GOI stake in Indian bank is also high at 82% but the bank has a high tier-1 ratio (would need negligible capital in the medium term).

As per our estimates, these banks are likely to struggle at raising capital to comply with Basel-3 capital adequacy even if government stake is raised to 90% at the current trading market prices. We note that LIC's shareholding has declined across most PSU banks in FY2017. However, we see an urgent need to diversify the shareholding base.

A large part of capital infused given out as dividends could have been avoided

Banks have been giving out a substantial part of the capital infused as dividends, ~45% of capital infused since FY2009 has been paid out as dividends. Since FY2009, US$10 bn of dividends have been declared by banks of which the largest beneficiary has been the government itself. The government and LIC invested ~US22 bn in this period. A drop in dividends or a dividend holiday could have substantially avoided a large amount of the capital infusion conundrum in public banks. The quantum of capital infusion required to meet Basel-3 guidelines has increased substantially, but banks continued to pay out high dividends until FY2015. It is only losses in FY2016-17 that led to a cut in payout ratios. It remains uncertain if banks will restore their payout ratios once they return to profitability.

Greater focus on improving NPLs of many of these banks would help improve the RoEs of these banks as credit costs are currently over 1% of assets. Normalization of these ratios should partly give adequate headroom to manage near term capital requirements.

Lower ROEs for public banks make it a challenge to raise capital

Return ratios have dropped sharply for PSU banks in FY2016 due to weak revenue profiles, high operating and credit costs. ROEs are likely to improve gradually to ~14% by FY2019E. Book value growth is likely to be slow down or turn negative as capital dilution is likely to continue at a significant discount to book value. Higher capital requirement to meet RBI guidelines on CCB and D-SIB will result in further reduction in ROEs.

Leverage is a concern; equity infusion a better solution than RWA optimization

We remain concerned on the leverage ratio, not only on CAR. RBI has recommended an upper cap of 4.5% (22X). The overall (on-balance sheet) leverage has been fairly stable at ~18.5X but there are nearly 11 banks where the ratio has crossed 20X. The off-balance sheet in most public banks is fairly low and hence the risk is driven by loans. These banks need to see RoE improvement, capital dilution and slow growth. This is also evident when we look at leverage ratio disclosures. Banks with lower tier-1 ratios also generally have lower leverage ratios, suggesting that further significant improvement can only come from further infusion instead of RWA optimization.

Source : Equity Bulls

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