Suggested structure of Bank Recapitalization bonds

Suggested principles for structuring of the Recapitalization (Recap) Bonds issued by Government of India (GOI) to fund equity infusion into Indian banks.

In structuring Recap Bonds, I believe it’s important we adhere to transparent, objective principles.

1) Should Recap Bonds count towards the holding bank’s statutory Liquidity Coverage Ratio (LCR) or Statutory Liquidity ration (SLR)?

I believe they should not, and the rationale for this is described below.

The principal aim of the Recap Bond is to provide funding to GOI to infuse as equity into banks. This is cash-neutral both for banks and GOI. (There is, of course, substantial risk transformation in the process – GOI takes on significant equity risk, thus increasing the capacity of banks to absorb risk)

As a principle, Reserve Bank of India (RBI) has to accept GOI bonds from banks under Liquidity Adjustment Facility (LAF) repo, when there is a net system liquidity deficit. Such systemic deficit can arise in two ways – one, GOI maintaining surplus cash balances with the RBI, and two, by way of RBI actions such as OMO sales, CRR, FCY sale and other INR liquidity withdrawing measures.

To either of this extent, RBI has to make good the systemic liquidity shortfall, and doing so via LAF repo does NOT tantamount to RBI (or GOI) printing cash and monetizing the fiscal deficit.

In the specific case of Recap Bonds though, there is no question of these generating surplus cash balances with GOI, since capital infusion into banks happens simultaneously. Likewise, RBI creating any systemic liquidity deficit has little to do with the cash neutral Recap Bonds and infused equity per se. Under these circumstances, allowing banks to repo the Recap Bonds under LAF can look like printing of money to fund equity infusion into banks, and is best avoided.

If banks cannot repo Recap Bonds with RBI under LAF, their ability to raise liquidity against them at times of stress is questionable. To that extent, suggest these bonds should not be part of LCR High Quality Liquid Assets (HQLA) or SLR.

2) What should the pricing of the Recap Bonds be?

The underlying risk of the Recap Bond – irrespective of whether this is issued by GOI or through any other intermediate entity – is GOI. The risk weight on the bond should reflect this, and therefore, the pricing of the bond should reflect this as well.

One aspect that could be of concern to banks, particularly with new accounting and valuation norms coming up, is the prospect of Mark to Market (MTM) fluctuations of the bond. To that extent, allowing the bonds to be in Held to Maturity (HTM) or Amortized Cost (AC) needs to be considered.

In addition, the actual financial risk of tenor mismatch needs to be minimized. One way of doing so is to have a floating rate coupon on the Recap Bond, say annual reset, linked to the 364-day T-Bill rate. That way, the price and duration risk of the bond is genuinely reduced, and not just through an accounting sleight of using HTM or AC.

3) What should the tenor of the Recap Bonds be?

For one, they should NOT be perpetual. An equity infusion by GOI matched by a perpetual bond issued by GOI looks and sounds too much like an accounting entry, and reduces the actual risk transformation that was envisaged. By the same token, the tenor of the bond should NOT be extraordinarily long.

Would suggest staggered issuances of say 7y, 10y, and 12y bonds, so as to avoid bunched up repayments. By that time, GOI should be able to monetize their equity infusions, and divest their holdings as well.

To provide for the event that equity disinvestments could happen even earlier, the Recap Bonds could have call features, allowing GOI to repay them earlier.

4) So where does all this leave us?

Overall, a combination of features of non-SLR non-LCR nature, rates linked to current GOI, floating rate coupons, callability, and HTM/ AC classification would mean the bonds would be fairly illiquid and hardly traded anyway.

Beyond this, would suggest there isn’t a need to restrict trading of these bonds. If a bank was to choose to sell the bond, at a discount, to an insurance company, mutual fund or a pension fund, they should be free to do so.

To the extent these bonds leave the banking system and enter the non-bank investor market, they could reduce the demand for normal government bonds, as was the case with some part of the UDAY issuances. However, suggest that itself is not sufficient cause to explicitly restrict trades in the bonds.