Whose premium is it, anyway?

First, the public sector banks acted smart. When the government announced its plan to buy back high-cost debt and replace it with new low-cost securities, most bankers privately said that they did not want to compromise on the premium on the old high-coupon paper.

After all, when a corporation prepays its debt, banks charge a premium. So why should the government buy back its own debt at a discount, they reasoned.

Now, it is the government's turn to act smarter. Some of the listed public sector banks want to return part of the government's equity.

By doing so, they can bring down their equity capital which in turn will prop up the earnings per share (arrived at dividing the net profit by the number of shares) and book value (net worth divided by the number of shares) and improve their valuations on the bourses.

They want to return the capital at par (that is, at Rs 10 per share). The government is not inclined to accept their shares at par when the market valuation of bank stocks is much higher.

Its reasoning goes like this. When a private sector promoter buys back its shares, it pays the market price. So why should the government be denied this benefit? After all, it has pumped in Rs 22,516.12 crore (Rs 2,251.612 billion) through  recapitalisation bonds over the last ten years to keep the public sector banking industry alive and kicking.

One-upmanship? Or is this the government's way of working out a package deal by forcing the banks to compromise on the premium income on the debt buyback?

There is no simple answer to these questions but the net result of the shadow boxing between the banks and North Block is there for everybody to see.

Bank stocks are yo-yoing by the day. An assurance that the Centre will not ask for a premium on banks' return of equity triggers a rise in share prices one day and a stray comment that it could claim a premium sees the stocks plunging the next.

Let's look at the nationalised banks' equity structure first. There are 19 banks that are owned by the Centre and governed by the Nationalisation Act.

Another eight banks --  State Bank of India and its seven associate banks -- are owned by the Reserve  Bank of India and governed by the SBI Act and SBI Associate Bank Act. The return of equity issue revolves around the nationalised banks that  essentially have three components in their equity structure.

First, there is the core equity that the banks carried from pre-nationalisation days and the different tranches of cash infusion by the government in the seventies and eighties. Then, there are special securities (bearing an interest of 7.75 per cent) in the nature of bonds in perpetuity.

Finally, there are the 10-year recapitalisation bonds that were pumped in to help banks shore up their capital base, eroded by the cumulative losses following the introduction of new income recognition norms in the early nineties.

Neither the irredeemable special securities nor the recap bonds have involved cash outflow from the government. For instance, when the government gave banks funds to invest in special securities, it was an accounting entry to shore up the banks' capital base.

The capital, in turn, was invested in special securities. Since there is no date of redemption for these securities, they are bonds in perpetuity and the net outgo from the government's coffers is the yearly interest payment.

Similarly, the recap bonds were an accounting entry and the funds were invested in 10-year bonds and the government's cost is only the interest outgo on these bonds.

It is a unique case of financial re-engineering where the owner (the government) also becomes a debtor. This was done because the government was not in a position to pump in hard cash. In the case of the perpetual bonds, there is no question of redemption but the recap bonds will mature in due course.

When they are redeemed, banks' equity bases will shrink automatically (their books will show an erosion in the investment portfolio and a corresponding erosion in capital base). If the government does not want bank equity to shrink, it will have to infuse hard cash.

In other words, banks will be able to free their capital, which can be invested in any asset (and not bonds in which they had invested following the unique recapitalisation exercise).

In fact, the first tranche of the recap bonds (floated in 1992-93)  matured in March 2003 but since the government did not have the money it quietly rolled them over! Since a few unlisted banks were involved in the rollover, the market did not react.

Some banks have already returned part of the recap bonds. Andhra Bank did so as late as on March 27 this year (Rs 50 crore or Rs 500 million).

Others like Bank of India and Bank of Baroda did so before they hit the market with their initial public offerings in 1997.  Now, more banks want to do the same.

Is there a norm for the return of capital? By tradition, the 'netting off' formula is followed. When a bank wants to return part of the government's capital, two things are taken into account: the dividend pay-out by the bank on the part of the capital it wants to return and the interest outgo from the government on the bonds in which the capital was invested.

If the dividend payout is less than the government's interest cost, then the bank is required to make good the gap while returning the capital.

There is another rule that governs the exercise. The Banking Companies Acquisition & Transfer of Undertaking Amendment Act 1995 says that no bank can reduce its capital below one-fourth of its capital base as on March 31, 1995. And, of course, no bank can bring down the government stake below 51 per cent.

Theoretically, there is nothing wrong if the government claims the market price when taking back its capital. If there is a tussle between the two on this issue, the government, being the owner, can certainly force the banks to cough up the premium.

It stood by the banks during the capital crisis by using taxpayers money to keep them running and since no commitment can be open-ended, the banks must bravely face the fact that it is payback time.

But the counter-argument could be that the government has no right to claim the market price because it cannot take credit for the bull run on banks scrips.

As an owner, it has fulfilled its financial responsibilities but on corporate governance, the government gets a big zero. In fact, the banks have been doing well despite the government! But this is an over-simplification of a complex issue.

The banks are resisting paying the market price on the shares because if they do so, they will need to use their reserves which in turn will bring down their capital adequacy ratios.

In other words, their capacity to create new assets will be severely impaired. This is sure to take the sheen off bank stocks.

By trying to bring down the government stake through this route, the banks are also indirectly trying to force the Centre to bring down its stake to 33 per cent.

The government had promised this but has not been able to do so because the standing committee on finance has been unable to formulate its views after years of deliberation.

For example, if Bank of Baroda is allowed to bring down the government's stake to 51 per cent through this route, two years down the line when the bank will need fresh capital, the government will have no choice but to cut its stake further. And that could be the right time for the government to realise the valuation of bank stocks by divesting its stake in the market.

Nobody is preventing the government from divesting its bank stake and making money. It can even auction the stake in different banks to the best bidder. But to do that, the government must learn how to unlock the hidden value in bank stocks.

Two successive Union Budgets promised to raise the voting rights in banks (it is capped at 1 per cent for state-run banks and 10 per cent for private banks irrespective of the equity holding of a stake holder) but nothing has happened yet.

Unless that is done, no bidder will quote the right price for a bank stake. Elsewhere in the banking sector, with over Rs 18,000 crore (Rs 180 billion) in market capitalisation, SBI is the world's most undervalued bank stock.

Lifting the cap on holdings by foreign institutional investors (it is capped at 20 per cent in SBI -- that too including the GDR holders -- in contrast to 49 per cent in private banks) will push the SBI stock to the roof.

The government must learn to be market savvy first and then claim the market price for its stake in banks.

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