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Ratings Paradox: Why Public Banks Enjoy High Credit Ratings Despite Losses

Credit rating agencies explain why government bank ratings remain high despite huge losses

The headquarters of UCO Bank in Kolkata. (Photographer: Sanjit Das/Bloomberg)
The headquarters of UCO Bank in Kolkata. (Photographer: Sanjit Das/Bloomberg)

On May 18, Punjab National Bank (PNB) reported the worst quarterly loss in the history of Indian banking – nearly Rs 5,400 crore on account of worsening asset quality. Despite this the bank continues to enjoy the highest possible credit rating.

Rating agencies, India Ratings & Research and CRISIL, rate Punjab National Bank as ‘AAA’, which indicates little or no possibility that the bank will default on a debt payment. The rationale both provide is that the bank, like many of its peers, is majority owned by the government and hence enjoys a sovereign-like rating.

In the case of most companies that are rated, after such a performance, credit rating agencies would have stepped in, reviewed financials and possibly downgraded ratings. For instance, in January, CRISIL downgraded Mangalore Chemicals and Fertilizers’ debt to a junk rating of ‘BB’ from an investment grade of ‘BBB’ on account of a loss of Rs 231 crore in the first half of that financial year.

In just six months ending March 31, the total number of bad loans on the books of Indian banks rose 80 percent to over Rs 5,00,000 crore, leading many of them to post huge losses. But, the ratings of PNB and the rest of the public sector banks remained unchanged.
BloombergQuint spoke to two Indian rating agencies to find out why.

The Secret Rating

A credit rating is a grade assigned to a borrower. It indicates the possibility of a default. So, if a borrower has a rating of ‘AAA’ - the highest rating - it suggests that there is little or no likelihood of a default. 

The rating agencies explained that the continued higher ratings are not a case of preferential treatment.

All government-owned banks have two ratings. The first is an ‘individual rating’, which is determined by assessing factors like the financial performance of the bank, the state of the industry, macro economic conditions, market share, and asset quality. This ‘individual rating’ is not made public.

The second rating is called the ‘issuer rating’. Over and above the individual rating, rating agencies also factor in the funding support available from the government.

The way a public sector bank is rated, at least our own criteria is, for most of these PSUs, it’s a support based rating. When I say support, it’s a fact that there will be both ordinary and extraordinary support available from the government, which is the biggest promoter.
Abhishek Bhattacharya, Director and Co-Head Financial Institutions, India Ratings & Research  
In the case of a government owned bank, we believe that because of the sovereign ownership, the credit profile benefits off that, the distance to default is that much farther, and there is an ongoing stream potential for capital infusion and other support.
Krishnan Sitaraman, Senior Director - Financial Sector Ratings & Structured Finance Ratings 

Both agencies admitted that there is a difference between the ‘issuer rating’ and ‘individual rating’ for all public sector banks, except in the case of State Bank of India and its associates, where both ratings are the same.

But the individual rating is not made public. And the issuer rating is ring-fenced by sovereign ownership. So is there a way to find out how credit worthy India’s public sector banks would be without the backing of their parent? Both agencies said there is.

The Third Rating

Apart from rating traditional debt instruments like the senior notes or bonds that banks issue from time to time, credit rating agencies also rate a quasi equity instrument called an Additional Tier-1 bond.

Additional Tier-1 bonds or AT-1 bonds, are also known as CoCo Bonds, and are quasi equity instruments. As defined by the Reserve Bank of India, these bonds absorb losses to the principal through a conversion to equity or a write down. 

Additional Tier-1 bonds came into being after the financial crisis, as an alternative to traditional debt instruments. At the time, in order to recover bad debt, lenders were forced to undertake long drawn out procedures.

The additional tier-1 bonds have built in thresholds that, once triggered, automatically convert debt into equity. As a result, when rating these instruments, rating agencies only take into account the financial ratios of the banks and not the support available from the government.

AT-1 is designed to take losses on a going concern basis. So in a year if your capital thresholds drop below the specified trigger, you can skip the coupon and it’s not cumulative. So the bond holder will not receive the coupon, but technically it won’t be a default.
Abhishek Bhattacharya, India Ratings & Research

The ratings of Additional Tier-1 bonds are therefore similar to banks’ secret individual ratings. Both rating agencies said that the difference between the ‘issuer rating’ and the Additional Tier-1 bonds are on an average two to three notches.

This, according to them, is also a fair reflection of the difference between the issuer ratings and the individual ratings of public sector banks.

The difference between the issuer rating and Additional Tier-1 rating of five public sector banks by CRISIL Ltd. Source: CRISIL
The difference between the issuer rating and Additional Tier-1 rating of five public sector banks by CRISIL Ltd. Source: CRISIL

As an illustration, UCO Bank’s issuer rating by CRISIL is AA- with a negative outlook, which according to the rating agency suggests a high degree of safety. But, the rating on its Additional Tier-1 bonds is BBB, which is just two notches above ‘junk’ rating.

Will Government Bank Ratings Fall?

Rating agencies have assigned a negative outlook on the ratings of all public sector banks, except State Bank of India and its subsidiaries.

With the RBI projecting a further deterioration in asset quality of public sector banks, by as much as 140 basis points, to 11% in its worst case scenario in 2016-17, there may be instances of ratings downgrades.

We are closely monitoring the situation and over the next 18-20 months there can be a negative movement in the rating. It is not an assured movement. There can be, going by the way we see the banks moving going forward. 
Krishnan Sitaraman, CRISIL 

According to the rating agencies, much will depend on the capital made available by the government this year. Both believe that the amount that has been promised will be sufficient to preclude any defaults.

The government has announced that it will infuse Rs 70,000 crore into public sector banks over a four year period ending 2019, of which around Rs 20,000 crore has already been spent. This year, the government has provided Rs 25,000 crore in the budget for the re-capitalisation of banks.

Both rating agencies have said that unless there is a major deterioration in the asset quality of banks, there is unlikely to be a large demand for capital, over and above the amount promised by the government.

As a result, they say that while a downgrade in banks’ ratings cannot be ruled out, it is unlikely.

Should Investors Be Concerned?

The credit rating of a public sector bank should not matter much to its equity investors, said Saurabh Mukherjea, Chief Executive Officer - Institutional Equities at Ambit Capital.

From an equity perspective, folks like us don’t lose sleep on the credit rating of PSU banks given the implicit sovereign guarantee available to them. The rating doesn’t significantly affect the cost of funding. For the equity calls that we make, we focus on the asset side and on the P&L rather than on the debt side.
Saurabh Mukherjea, Ambit Capital

The bottomline then is that a public sector bank’s Additional Tier-1 bond rating is a more accurate representation of its financial performance than its issuer rating. And while the rating on these special bonds may fall this financial year, issuer ratings are secure thanks to the government’s providence.