How to Stabilise Indian Banks

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Publication: The Economic Times Mumbai;Date: Jan 24, 2013;Section: Editorial;Page: 19

How to Stabilise Indian Banks PSU bank shareholders can share governments solvency liability through coercive rights
YAKOV AMIHUD & T SABRI NC

Indian banks are reported to be experiencing an increase in non-performing assets (NPA) in their loan portfolios due to loans that went awry. This may considerably weaken banks solvency. For example, NPA of 4% of assets, with recovery rate of 50% and capital ratio of 10%, means that the bank capital including provisions will decline by about 20%. While this is not a cause for alarm, it induces a repair of the banks balance sheet. The best way to do it is by forcing banks with large NPA to issue coercive rights. Banks should offer existing shareholders rights to buy additional shares at a discounted price. Suppose that a bank whose stock price is . 200 offers its shareholders one-for-one rights with an exercise price of . 100. After the rights are exercised, the share price will drop to . 150 because there are two shares that are claims on the former . 200, plus the newlyinjected . 100. Stockholders will be indifferent because their wealth has not changed. They now own two shares that are together worth . 300, whereas earlier, they had one share worth . 200 and an additional . 100 in cash. Those who do not wish to take up the . 100 right can, instead, sell it in the market, where its price will be . 50, which exactly covers the decline in the stock price (from . 200 to . 150). The rights are coercive because a stockholder who does not contribute the . 100 of exercise price or does not sell the right to someone who will do so will suffer a price decline of . 50 without the offsetting gain of . 50. Therefore, existing shareholders will either exercise the rights themselves or sell them to someone who will. As a result, the rights offering is guaranteed to raise the desired amount of capital, which equals the number of rights issued times the exercise price per right. An example of that is the rights issue of Banco Santander, the largest bank of Spain, which announced on November 10, 2008, that it would raise 7.2 billion through a rights issue. The bank would issue one rights for each four existing shares, with the exercise price set at 4.50, while the stock price was 8.34. The bank said that the rights issue, which represented almost 14% of the banks capitalisation, was intended to boost its core capital ratio. At that time, the banks core capital stood at 6.31% of assets and was expected to drop. On November 28, 2008, the bank announced that investors had signed up for the entire issue. Other major banks used coercive rights issues to raise capital. Among them are HSBC in 2009, where 97% of the issue had been subscribed, and Banca Popolare di Milano, with a subscription rate of 94%. Importantly, selling the rights at a discount to the market value or the book value of the bank does not make the existing shareholders worse off because after they exercise the rights, they retain the same proportional ownership of the banks assets. This is particularly meaningful in public sector banks, where the government is expected to exercise the rights and, thus, retain its share of control of these banks. The only purpose of the deep discount is to guarantee that the public shareholders contribute the desired amount, too, to shore up the banks balance sheets and enhance their solvency. From the governments viewpoint, this method of raising capital saves on its cost in keeping the banks solvent. Suppose a public sector bank is in a precarious situation. If it fails, the government alone will have to bail it out, thus, the entire onus of injecting new capital will be on the government. The public stockholders will, in fact, take a free ride on the governments guarantee. In contrast, the rights issue ensures that the public stockholders too contribute right now, ahead of the potential bank failure to the stability of the banks. That is, the rights ease the governments burden in case of a bank failure by making more private equity capital available to the bank. To illustrate, the Union government has recently approved a capital infusion of . 12,517 crore into state-run banks over the coming fiscal year. The government ownership in these banks is nearly 60%. Usage of coercive rights means that the government will be able to reduce its contribution to less than . 7,500 crore while retaining its ownership share intact, with the remaining amount in excess of . 5,000 crore coming from public shareholders. Suppose, on the other hand, a state-owned bank turns out to overcome the financial difficulty and the capital injection has been unnecessary. Then, the bank can distribute the excess equity that it has back to shareholders by way of dividend. Because the governments share of the banks equity remains unchanged before and after the rights exercise, it will receive back exactly the amount it has contributed, with no loss to itself. In summary, forcing troubled state-run banks or any bank to issue coercive rights to their shareholders can only help the government and not hurt it. It will greatly relieve the onus that the government is now subject to in its guarantee of the banks solvency. It is desirable to do it now before problems erupt, because greater equity will preempt insolvency problems. The major benefit is having stable banks and a dependable financial system that will foster economic growth in India.

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How to Stabilise Indian Banks

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(Y Amihud is Ira Rennert Professor of Finance at the Stern School of Business, New York University, and T S nc is head of research at Cafral, RBI) AFTERTHOUGHT The safest way to double your money is to fold it over once and put it in your pocket. Kin Hubbard, American cartoonist, humorist & journalist

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25-01-2013 11:45