RBI’s Large Borrower Framework Needs To Address Bond Investor Constraints

The Reserve Bank of India’s (RBI’s) proposed guideline to create an overarching ceiling on total bank borrowing by a corporate entity can address the concentration risk for banks while providing a fillip to bond market issuances, provided demand side constraints are addressed effectively, says India Ratings and Research (Ind-Ra).

RBI’s discussion paper aims to improve the credit supply from the non-banking channels for large borrowers while also aiming to reduce concentration risks for banks (which shot up in FY16 yoy). However, for a meaningful deepening of the corporate bond markets, multiple enablers will be needed so as to improve the appetite of domestic institutional investors. The regulatory guidelines by the Insurance Regulatory and Development Authority and Pension Fund Regulatory and Development Authority discourage investment in corporate bonds which are rated below the ‘AA’ category. This shuts the door on the needy lower rated corporates and under the proposed framework can put additional pressure on their ability to diversify their funding mix. The recent norms to change mutual fund investment patters mandated by the Securities and Exchange Board of India to address concentration risk for mutual funds, could also impede the development of an efficient market, since it imposes ceilings on sectoral and group exposure limits. Ind-Ra believes that the bankruptcy code which was cleared this month will take some time before it starts to offer any tailwind to the corporate bond market. While the balance sheet driven stress will take a while before it starts recovering, it would take a demonstrated cycle of insolvency resolution under the new laws to instill investor confidence in the lower rated paper. The bond market is already facing pressure from the recently issued UDAY bonds. Thus the quantum jump in the corporate bond issuances in an environment of limited investor’s appetite could potentially create pressure on the overall bond yield curves.

Ind-Ra has consistently focused on the concentration risk building up in public sector banks and incorporates the risk from single name concentration in its stress test for banks. Ind-Ra believes that the full implementation of Basel-III mandates would address the single name concentration issue to a large extent. However, the current framework takes a more systemic approach to address the concentration risk. The proposed framework aims at rationing the appetite of banks while taking incremental exposure to large corporate borrowers. Banks would be penalised on taking any exposure beyond 50% of the incremental requirements of specified borrowers who have significant aggregate fund based credit limits sanctioned by the banking system (ASCL). The ASCL limits proposed for borrowers are at INR 250bn, INR 150bn and INR 100bn for FY18, FY19 and FY20 onwards respectively. For any specified borrower defined as above to grow entirely through the banking system, the proposed guidelines could add 150-200bp of additional cost as per Ind-Ra’s estimate.

Large corporate houses having current fund based credit limits exceeding INR100bn (including all subsidiaries and special purpose vehicles having fund based facilities by both domestic and global branches of Indian banks) are likely to increasingly test markets and also possibly tap NBFIs for working capital funding and smaller limits.

As per Ind-Ra’s estimate about 20% of bank credit would be to entities having aggregate fund based limits above INR100bn at present including 5-6% towards deeply stressed corporates. If implemented effectively, this framework has the potential to address the significant concentration risk being posed by stressed corporates that currently account for 40% of the banking system’s net worth over the medium term. The median “top 20 exposure to net worth” for public sector banks was uncomfortably high at 220% as of March 2015 and is estimated to have gone up further in March 2016.

Ind-Ra expects Indian banks may need up to INR1trn over and above their Basel-III capital requirements to manage the concentration risks arising out of their exposure to highly levered, large stressed corporates. Of the INR1trn, public sector banks may need INR930bn. The amount 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.

The recommendations of the proposed framework have the potential to gradually destress the banking system’s exposure to large levered corporates and provide the much needed impetus to the corporate bond market development. However, this can potentially impact growth in the medium term, unless backed up by easing of the demand side constraints in the transition phase. This is definitely the right time to put such a framework in place before the capex cycle kicks in.

About the Author

Abhishek Bhattacharya
Director & Co-Head – Financial Institutions, India Ratings & Research