Wednesday, March 23, 2011

Recapitalising RRBs : Green capital – an opportunity for DEVELOPMENT FINANCE INSTITUTIONS!!

The Finance Minister in the Budget presentation (2009-10) while commenting on the status of the RRBs mentioned that after the process of amalgamation, the recapitalization of RRBs with negative networth would be a priority area for the Government. This is particularly true as RRBs are expected to be the key players for enabling greater financial inclusion and permitting a range of experimentation in financial inclusion like Business Correspondents, franchisees with technology usage in rural hinterlands. These elucidations are also backed by government action asking RRBs to undertake an aggressive branch expansion programme and open at least one branch in 80 uncovered districts of the country as also the GoI setting up a Committee to look into aspects concerning the capitalization of weak RRBs (particularly) and also suggesting a roadmap to raise the CRAR of RRBs to nine per cent by March 2012.
With the amalgamation process on-stream in the last four years, 196 RRBs have now been merged into 82 RRBs. The monetary policy of RBI (oct, 2009) states that the process of recapitalization has since been completed with 27 RRBs fully recapitalized with an amount of Rs 1,796 crore as on 31 July 2009[1]. The available information as on 31 March 2009 also suggests that 22 RRBs have registered losses with accumulated losses to the tune of Rs 2325 crore as on 31 March 2009[2].
The newspaper reports also inform of GoI intending to infuse Rs.2000 crore towards recapitalisation of RRBs. However, capitalising the RRBs through tier 1 capital has connected issues, viz; concomitant contributions by the sponsor banks and the State Governments; with the later often delaying contributions or showing reluctance for the same. It is in this context that an option of enlarging the Tier II capital of RRBs has been viewed in this brief paper. Rejigging the Tier II capital is also equally (or perhaps the second best) measure of a bank's financial strength  from a regulators stand point. With forms of banking capital largely standardised by the Basel committee, and countries (regulators) accepting this with marginal modifications and suitable legislations, expansion of Tier II capital in RRBs looks a possibility, though limited.
2        Enhancing Tier II capital:
While tier 1 capital is considered as the core and more reliable form of capital, expansion of Tier II capital also brings efficiency gains to the organization by enhancing its leveraging capabilities. In the existing literature, there are several classifications of Tier II capital viz; undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Normally, supplementary capital is considered as Tier II capital up to an amount equal to that of the core capital[3]. Subordinated debt / debenture or subordinated loan is a chief component of the Tier II capital in banks; its a debt which ranks after other debts should a company fall into receivership or be closed. Thus, subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy. Because subordinated debt is repayable after other debts have been paid, they are more risky for the lender of the money3. It is normally unsecured and has lesser priority than that of an additional debt claim on the same asset.
As a measure to enhance Tier II capital in RRBs through subordinated debt, DEVELOPMENT FINANCE INSTITUTION could consider subscribing to the subordinated debts/ or subordinated debenture issued by interested RRB. These subordinated debts or debentures could be customized with a clause restricting their end use of the proceeds to “Green initiatives” which is broadly defined by NABARD. Alternatively, the subscription to the subordinated debt / debenture floated by RRBs could be made after ensuring that the amounts so sought has already been used for funding green initiatives only (please see illustration).

Recapitalising RRBs through issue of Green Capital

Option 1
Funds clean technology Investments …
Or Environment 
Supportive ventures like forestation, green construction, carbon ventures etc

Option 2
RRB uses the funds mobilised for clean technology Investments …
Or Environment 
Supportive ventures …… etc

3        The Green initiatives
Environment and climate change has been concern which has been fiercely debated world over. While many of the projects being supported or funded by banks do possess less polluting solutions or mandatory pollution control mechanisms or devices, these should not qualify for coverage under this proactive venture for green capital support. These initiatives should be on its own be environmentally friendly or introduce new venture permitting Zero Emission technologies. These projects will have to be clearly defined viz; 

  1. Clean technology investments[4] 
  2. Green construction projects, Waste recycling etc
  3. Wasteland development projects- Land reclamation, sand-dune stabilisation etc
  4. Forestation projects
  5. Plantation and Horticulture projects
  6. Approved Carbon ventures, energy efficiency projects viz; solar pumps, solar energy

4        Some features of the suggested subordinated debt instrument[5]
Ø      How much of subordinated debt:

The amount eligible for inclusion in Tier II capital as subordinated debt will be subject to a maximum ceiling of 50% of the Tier I capital. Further as per extant instructions (for foreign banks) (ref: RBI circular no: DBOD. No. IBS. BC. 65/23.10.015/2001-02 February 14, 2002), the total of Tier II capital should not exceed 100% of Tier I Capital.

Ø      Features of the product:

Subordinated debt eligible to be considered as Tier II capital must:
1)     Have an original maturity of at least five years.
2)     Be subordinated to the claims of depositors
3)     Be unsecured
4)     The subordinated debt is not redeemable before maturity without prior approval of regulator.

Ø      Description of the terms of issuance of subordinated debt

The RRB may not be required to obtain shareholder approval for the issuance or for prepayment of subordinated debt. However, if Reserve Bank of India agrees to issuance of such capital[6], then such borrowings made by RRBs in compliance with the guidelines, would not require prior approval of RBI.

However, RRB may be required to obtain the RBI (regulators) prior approval to issue subordinated debt only if it has a negative networth regardless of whether the subordinated debt is intended to count as capital. Therefore, in such cases the RRB would be required to seek approval to issue or prepay subordinated debt.

Ø      Documentation:

The RRB should obtain a letter from the subscriber (DEVELOPMENT FINANCE INSTITUTION in the instant case) agreeing to give the loan for supplementing the capital base. The loan documentation should confirm that the loan given by subscriber would be subordinated to the claims of all other creditors of the bank. The loan agreement will be governed by, and construed in accordance with the law. Prior approval of the RBI should be obtained in case of any material changes in the original terms of issue

Ø      Redeeming subordinated debt:

Once any scheduled payments of principal begin, all payments shall be made at least annually. The amount of subordinated debt eligible for inclusion as Tier II capital is reduced by 20 percent of the original amount of the instrument (net of any redemptions) at the beginning of each of the last five years of the instrument’s life. Thus, subordinated debt with less than one year to maturity is not normally included in Tier II capital

Ø      Reserve requirements:

The total amount of RRB’s borrowings (under subordinated debt) is to be reckoned as liability for the calculation of net demand and time liabilities for the purpose of reserve requirements and, as such, will attract CRR/SLR requirements
5        Who benefits? 
This initiative could be considered as a win-win proposition for both the participating institutions viz; DEVELOPMENT FINANCE INSTUTITION and RRBs.

The twin objectives of DEVELOPMENT FINANCE INSTITUTION viz; Business and institutional development could be clubbed to address environmental concerns through green-capital or pro-environment investments. Further, with subordinated debts typically carrying a higher rate of risk and for longer durations normally differentially priced. Accordingly, contributors of subordinated debt (like DEVELOPMENT FINANCE INSTITITION in the instant case) could seek a higher compensation for the extra risk and longer duration.


Thus, the “green capital” could be priced in such a way that the price is profitable to DEVELOPMENT FINANCE INSTITUTION as also beneficial to the issuing RRB.  The pricing could be such to incentive the receiver Bank to commit its capital to a specified field of activities that would also earn at market related rates. With such enticements, there could be a compulsion for the RRB to diversify their lending activity and also address the concerns of funding environmental friendly projects and meeting the mission of sustainable development. 

[1] RBI: second quarter review of Monetary Policy 2009-10
[2] IDD, NABARD-HO, Mumbai
[3] Ref:   accessed on 13 Dec2009
[4]  Example : livestock is said to account for more than 20% of all carbon emissions.  Mootral is a new feed additive for ruminants, biotechnologically extracted from garlic, that helps animals reduce their methane emissions. 
[5] Could be very similar to the RBI instructions issued to foreign banks - RBI circular no : DBOD. No. IBS. BC. 65/23.10.015/2001-02 February 14, 2002
[6] if a suggestion is made by the Chakravorty Committee after weighing the pros and cons of the suggestion

Works at NABARD for poor HH / was Research Affiliate at CDS, Tvm / was Visiting Faculty on microFinance for MBA students NMIMS, Mumbai.