With little possibility of the government shareholding in public sector banks coming below 51 per cent, at least so long as the government is dependent on the Left to stay in office, and also given the resources constraint, there is every possibility of the public sector banks' growth getting hampered for want of capital.
It is perhaps this that has prompted the banking supervisor to liberalise ways in which banks could add to capital, without diluting equity. Early this year, it allowed the use of perpetual bonds (to augment tier I capital), and other forms of debt instruments (for tier II capital).
There were two caveats: that the instruments would be in rupees, and be subject to the usual CRR/SLR prescriptions. No bank took advantage of the changes - the rupee debt market is just not developed enough to cater to long-term bonds, a point I have argued in an earlier article in this paper ("Issues in long-term debt market", August 11).
Last month, the RBI has made two major relaxations - the bonds can now be in foreign currency, and perpetual instruments would not attract CRR/SLR levies. In response, several banks, including ICICI and UTI, have announced their intention to raise tier II capital in this form.
Reportedly, some public sector banks are also considering the idea. (Incidentally, one sometimes wonders whether the latter are making optimum use of existing capital, before rushing to issue additional capital, whether tier I or II.)
While innovative and hybrid instruments, combining the characteristics of equity and debt were envisaged in the Basle I capital accord of 1988, they have really gained momentum only in recent years.
Indeed, the holy grail of innovation in capital markets is a structure, which is debt for tax purposes - in other words, the cost or interest is deductible for tax purposes - but equity as far as the regulator is concerned.
Incidentally, another area for brilliant (and costly) investment bankers is to devise highly complex debt instruments, so complex that few investors can analyse and understand them fully, or price them properly - the ultimate cleverness lies in off-loading each element of risk in the derivatives market, and still leave for the structurer a fat, relatively risk-free margin.
To be sure, such structures cannot be patented and, while the first mover advantage is significant, it does not last very long. Seeing some of the recent developments in the debt market, I often wonder whether structured finance has not become even more complex than currency and interest rate derivatives.
The complexities are leading to major problems in corporate takeovers and interpretation of the rights and obligations of different creditors in corporate restructuring exercises. But more on some of these cases in a later article.
Value at Risk and capital: As a student of financial markets, I find the financial stability reports issued by the likes of the Bank of England, the International Monetary Fund and the European Central Bank, of great interest.
The latest BoE report discusses one interesting feature of risk and returns. By now, value at risk as a measure of risk has been well accepted by the banking system as also regulators. Indeed, regulators are prescribing capital for market risk in relation to VaR. The BoE analysis suggests that trading profits as a multiple of VaR have been rising.
For instance, trading revenues of large complex financial institutions increased 50 per cent in 2005. But this was accompanied by only a very small increase in VaR.
Given the relationship between risks and rewards in highly efficient markets, such a result points at two possibilities:
The banks have become more efficient at diversifying risks - as is well-known, diversification is the only "free lunch" in efficient markets, adding to rewards without adding to risks.
And alternately, the conventional calculations of VaR are not a good measure of the market risk.
Unfortunately, the BoE does not express an opinion about which explanation it prefers.
The role of the MoF: A report in this newspaper last Monday conveyed that the ministry of finance is drawing the attention of public sector bank managements to the "slope of the yield curve and the tenure buckets of bank loans".
The MoF also suggests that "such a stiffening opens up the probability of maximising profits by switching from shorter end to the longer end of the maturity spectrum".
Earlier, too, the MoF had publicly expressed its thoughts about future interest rates. It is so refreshing to know that the ministry has expertise in yield curves, asset-liability management, and forecasting of interest rates. It also seems to have a very poor opinion of the expertise of the top managements in public sector banks and their boards, appointed by the ministry itself: else, why should it be interfering in and offering unsought advice on technical subjects like yield curves? What exactly is, or should be, the role of the ministry in managing banks?