Friday, July 5, 2013

Raising capital requirement of banks and financial institutions

As soon as the banking sector regulator's intention of raising capital requirement of banks and financial institutions became evident last week, Sanjib Subba updated his Facebook status saying: "We[should] target [raising paid-up capital of commercial banks to] Rs 5 billion in the next three years and Rs 10 billion in the next 5-7 years [from the existing Rs 2 billion]."

The pointer made by the CEO of National Banking Training Institute seems timely, considering the money squeeze that flares up in the banking sector every now and then.

Earlier this year, the banking sector felt the credit squeeze a couple of times following shortfalls in government spending, lower growth in remittance income and relocation of deposits from banks to government coffers due to seasonal tax payments.

The result: the average short-term interbank rate ¿ the rate of interest at which banks lend money to each other -- jumped to as high as 6.79 percent in mid-February from as low as 0.6 percent in January. The rates then moderated to 1.85 percent in the last week of March, but only to rise to 6.8 percent in the last week of April.
Such sudden hikes in interbank rates ¿ which clearly indicate credit tightness in the banking sector -- could precipitate a decline in private sector investment, make the banking and financial sector unstable, and eventually affect the real economy.

Currently, the mainstays for the country's banking sector are spending made by the government and the hundreds of billions of rupees sent home by overseas Nepali migrants. Money received from these activities boost deposits of banking institutions. But since deposits are liabilities, banks and financial institutions need to extend loans to generate income. However, deposits cannot be transformed into loans without maintaining adequate capital buffers.

As of now, commercial banks need to maintain a capital buffer -- known capital adequacy ratio -- of 10 percent. These ratios -- which are measures of the amount of capital held by banks and financial institutions in relation to risk-weighted credit exposures -- stand at 11 percent for development banks and finance companies. In other words, commercial banks should hold capital of at least 10 percent of the size of their credit exposures, while development banks and financial companies need to maintain capital of at least 11 percent of the size of their credit exposure.

These ratios are set by Nepal Rastra Bank, the banking sector regulator, to ensure banking institutions are able to absorb certain losses in case of bankruptcy. So these buffers ultimately protect the interest of depositors, who park hard-earned money in banking institutions, and prevent financial risks from building up in the country's banking system.

Lately, however, the level of these buffers at banks and financial institutions has been gradually declining. The average capital adequacy ratio of commercial banks stood at 11.30 percent as of mid-April, according to Nepal Rastra Bank's latest report. Although the figure shows holding of an extra 1.30 percentage points of capital fund by commercial banks, the discomforting part is the regulator's instruction to maintain a capital buffer of at least 11 percent to be able to distribute cash dividend to shareholders.

Since banks and financial institutions are profit-making institutions and thus want to please shareholders by giving better returns, they would want to maintain a capital buffer of at least 11 percent despite knowing that the minimum regulatory requirement is only 10 percent. Considering this, it would not be an exaggeration to say that banks are currently operating with very little extra capital, which is constricting their ability to lend.

Although one may argue there is not much credit demand these days due to the not-so-encouraging investment climate, banking institutions will gradually need to stimulate lending to meet the country's target of attaining a seven percent growth rate till 2022 to graduate from the category of least developed country to developing country. And data shows there is ample room for credit expansion, as lending of banks and financial institutions as a percentage of GDP currently stands at only 59.2 percent.

But to boost lending, institutions must first raise their capital level as pointed out by Subba.

Some years ago, when the central bank instructed banks and financial institutions to raise their capital, many did so by retaining certain levels of profits made every year. But if the regulator asks banks to raise paid-up capital to, say, Rs 5 billion within the next three years, and to Rs 10 billion within next seven years, then this technique might not work for all, as many may not be able to earn such huge profits in such a short period of time. And even if they do, the concept of retaining every bit of earning would only disappoint shareholders, who seek some return on their investments.

"And if shareholders lose interest, the quality of banking institutions would gradually deteriorate, generating more risks in the financial sector," Ajay Shrestha, CEO of Bank of Kathmandu, told Republica.

This leaves banks and financial institutions with other options for raising capital, such as, asking promoters to inject cash, mergers, or leveraging -- that is issuing corporate bonds.

This fiscal year at least five commercial banks resorted to leverage financing to raise capital levels and issued Rs 3.15 billion worth of debentures. But since debentures are identified as Tier 2 capital -- which make up only 40 percent and 50 percent of the capital funds of banks and financial institutions respectively -- their contribution alone cannot boost up capital buffer.

This leaves banks and financial institutions with two other options: merger and coaxing promoters to inject more cash.

"Currently, many promoters are not as enthusiastic about putting money from their own pockets as return on equity is gradually declining," Shrestha said.
At the end of the third quarter of the current fiscal year, the average annualized return on equity of commercial banks stood at 14.75 percent as against around 20.66 percent around three years ago. This is because of fierce competition.

Add to that the mandatory provision of submitting income sources and tax receipts prior to making investment in banks and financial institutions, and potential investors become more apprehensive about opening up their wallets.

"In a country where the private sector is not as transparent, [luring investment to banking institutions] is not an easy thing to do," Shrestha said.

This leaves banks and financial institutions with the only option of merger to raise capital, which is probably the fastest way of meeting the minimum regulatory capital requirement.

But would merger of banking institutions with very little free capital build resilience and stimulate lending? This is a big question that is yet to be answered as consolidation of Global IME Bank has created doubts about this pill called merger.

To recap, the merger of Global Bank with IME Financial Institution and Lord Buddha Finance last July did raise paid-up capital of the consolidated unit to Rs 2.18 billion. At the same time, the capital adequacy ratio of the merged unit also jumped to 12.68 percent. But by the end of the third quarter of the current fiscal year the consolidated unit's capital adequacy ratio fell to 11.21 percent, forcing it to scout for other options to raise additional capital.

This shows merger of institutions with very little free capital would only expand the balance sheet size of the consolidated units without addressing the problems that can raise the specter of credit crises and ultimately destabilize the financial sector and the economy.

This, however, does not mean mergers are ineffective in solving many problems faced by banking institutions, as they can expand single obligor limit that allows lenders to give bigger-sized loans to single parties. Mergers can also reduce operating cost, including fixed costs like salaries.

Currently, the private sector-led banks spend around 20 percent of their total operating income on staff salaries. Upon merger this cost could come down drastically but not many institutions that have merged so far have been able to do so, as they try to accommodate all staff members -- except CEOs -- of units that have been roped in in the merger process.

Considering this, "it would be appropriate if Nepal Rastra Bank allows existing banks and financial institutions to operate with whatever capital they have and apply new capital thresholds on new applicants, as those interested in expanding their lending abilities will definitely inject capital on their own", Sashin Joshi, CEO of the newly merged NIC Asia Bank, told Republica.

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