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Banks face huge concentration risks

Indian banks are faced with a huge burden in view of their exposures to large stressed corporates, says a special study by Indian Ratings and Research:

Indian banks would require up to Rs1 trillion over and above their Basel-III capital requirements to manage the concentration risks arising out of their exposure to highly levered, large stressed corporates. This is the prediction given by India Ratings and Research in a special commentary on financial institutions in the country.

Of this amount, public sector banks will need Rs930 billion, which is equivalent to an equity write-down of about 1.7% of the banks’ risk weighted assets (RWA), and represents the loan haircut that banks may face to revive the financial viability of distressed accounts. All these exposures are currently treated as performing and carry minimal loan loss provision of 5% or less, says Indian Ratings.

The agency warns that the shortfall may significantly increase the government’s equity injection requirement compared to the Rs700 billion announced on 31 July 2015. “The access to equity will be a critical input to rating of additional Tier 1 (AT1) bonds, as these instruments carry loss triggers linked to the bank’s common equity tier 1 (CET 1) ratio,” says the study.

The study also mentions that if corporates are able to reduce borrowing costs by 100bp, the shortfall may reduce to Rs760 billion from the estimated Rs1 trillion.

HAIRCUT

While Ind-Ra’s analysis indicates potential haircut on a blended basis at around 23%-24%, banks may also consider a senior-subordinated structure of the current exposure. Under this, banks may decide to structure their exposure, particularly to infra projects at 80% in senior debt (to be backed by cash flow) and the remaining 20% as subordinate debt (which can potentially be written off but at a later stage).

India Ratings’ associate director Abhishek Bhattacharya, who headed the study, said 30 large, stressed corporates, each with aggregate bank debt of over Rs50 billion totalling to about 7%-8% of the overall bank credit were analyzed. “Bank loans to all these corporates are accounted as performing. The power and other infrastructure sectors account for 50% of this exposure while the iron & steel sector accounts for another 32%. Aviation, ship-building, sugar and textile bring up the balance. These companies have seen a significant increase in their leverage over the last few years during a period of weak operating environment. The median debt-to-equity ratio for this set increased to 4x-6x in FY15 from under 2x in FY10 while the median market-cap-to-debt ratio contracted to 5%-7% from 35%-50%,” he said.

CUT IN CURRENT EXPOSURE

The study reveals that banks would need an average 24% reduction in their current exposure to ensure reasonable debt servicing (1.5x interest coverage (ICR)) by these corporates on a sustained basis. “For public sector banks, which have about 90% share of this exposure, this amount comes to around Rs930 billion or about 1.7% of their FYE15 RWA. Assuming the banks provide for this haircut either as a provision ramp-up or by building additional capital buffers, this exposure can add significantly to the estimate of Rs2.4 trillion of the CETI needed for the Basel-III transition,” says the study.

India Ratings expects private sector banks and large PSBs to be better placed in handling potential credit cost hikes from these large stressed corporates, given their sufficient operating and capital buffers. However, mid-sized public sector banks will be the most affected, given their thin operating margins and weak capitalisation, says the study.

According to the rating agency, while companies in the power, other infra and iron & steel sectors would need a haircut of 20%-30%, few deeply levered names in the textile and sugar sectors might require a higher amount of debt reduction (30%-40%). In value terms, the amount of debt reduction needed is around Rs1.04 trillion, of which the share for public sector banks is about Rs930 billionn. This corresponds to around 1.7% of their combined RWA at FYE15. The agency feels that the public sector banks would need to build this additional amount through additional CET1 to mitigate any possible concentration risk arising out of these large ticket exposures. “Our overall estimate of the capital requirement for public sector banks for the Basel III transition till FY19 is Rs2.4 trillion (at 14.5% blended RWA CAGR) and the estimated haircut could amount to another 50%,” it says.

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