Mobilisation of Share Capital by DCCBs in Kerala State

A Case Study

Manikumar S & KPR Udupa, DGMs/FMs, BIRD, Lucknow

Presentation Outline

• Study Objectives

• Methodology

• ST co-operative structure in Kerala State: A Profile

• Study Observations: Data analysis / results

• Key Recommendations• Increasing capital funds

• Reducing capital charge on assets.

Study Objectives

• To understand and document the present status of Share Capital held by the DCCBs in Kerala State;

• To understand the approaches adopted by the DCCBs to enhance their Share Capital & Capital Funds including increasing their membership base;

• To obtain suggestions [having policy ramifications] from DCCBs and to propose changes in existing guidelines governing mobilisation of Share Capital and Capital Funds by co-operative credit institutions;

• To provide a road-map for DCCBs/StCBs of the country to increase Share Capital and their Capital Funds commensurate with business growth, for complying with the regulatory requirements.

Methodology

• The study was conducted in the State of Kerala taking into account the uniqueness of their cooperative structure

• The study is based on both Primary and Secondary data

• Primary data has been collected from

• 14 DCCBs in the State of Kerala.

• 3 DCCBs [Thrissur, Kozhikode & Malappuram] during field visits

• Interactions held with the officials of these and other DCCBs/PACS

• Secondary data sourced from ENSURE database [of NABARD], from Regional Offices of NABARD, Inspection reports, etc.

Importance of Capital

• Banks are highly leveraged entities

• Share Capital is the cornerstone of a Bank’s financial strength

• Reassures Creditors, Engenders Regulatory Confidence

• Post Latin-American debt crisis, Basel Committee resolved to halt

erosion in capital standards in the banking system

• Basel Accord 1988: stipulated minimum CRAR of 8%

• In India, the stipulation was pegged higher at 9%.

Components of Capital [1/2]

• Tier I [Core Capital]

• Paid-up Share Capital

• Share Capital Deposit

• Statutory and other disclosed Free Reserves

• Capital Reserve [from sale of assets]

• Unallocated Surpluses

• Eligible Innovative Perpetual Debt Instruments [IPDIs]: Max 15% of T-1

• Any other instrument notified by the RBI.

Components of Capital [2/2]

• Tier II [Supplementary Capital]: {max 100% of T-1}

• Undisclosed Reserves

• Revaluation Reserves [discounted to 45%]

• General Provision & Loss Reserves [excess]: {max. 1.25 % of Total RWAs}

• Provisions for Standard Assets

• Investment Fluctuation Reserve [IFR]

• Hybrid Debt Capital Instruments / Quasi Capital

• Sub-ordinated Debt / Long Term Sub-ordinated Debt [Max 50% of T-1].

Capital Adequacy in the Co-operative Credit System

• Co-operative Banks are

• Member-owned; Limited-geography; Democratic & Member-managed

• Closely-held entities, can raise capital only from within their

membership fold

• Share capital augmentation through the concept of share linking to

borrowings

• In some States, there is a maximum cap on such share linkage!

• Result: further reduction in ability to increase share capital.

Capital Adequacy: Importance of a responsive Regulatory Policy

• Considering their financial strength, a progressive approach to

CRAR prescribed by RBI:

• Minimum CRAR of 7%, w.e.f. 31st March 2015; 9%, w.e.f. 31st March 2017

• Permitted to issue

• Innovative Perpetual Debt Instruments [eligible for Tier I Capital]

• Long Term [Sub-ordinated] Deposits [eligible for Tier II Capital]

• Tier I to include Nominal Share Capital, Admission Fees held in the

nature of Reserves & Special Reserve u/s. 36[1][viii] of IT Act, 1961.

ST Co-operatives in Kerala: A profile

• Kerala State ranks 22nd in area and 14th in terms of population

• The State is home to

• 1,647 PACS, holding a staggering Rs. 72,724 crore of public deposits

• It constituted 72% of the total deposits held by all PACS in the country

• TN ranks next with Rs. 7,992 crore! [but from 4,436 PACS]

• 14 DCCBs with aggregate deposits of Rs. 47,771 crore

[Source: NAFSCOB data 2015-16]

• Govt. of Kerala not a signatory to the VC package.

Study Observations

• Active capital management strategy important for survival of co-

operative credit institutions

• Faster than expected growth in deposits and loan businesses

• Higher capital requirement due to increase in Risk Weighted Assets

• Adequate capital ensures that the bank remains Balance Sheet

‘solvent’!

• Reinforced the belief that Capital is Perpetual…

• …however, distribution of surplus to capital providers IS Obligatory!

Study Observations

• In Kerala, DCCBs adopted varying approaches to improve CRAR

• Numerator Management Approach

• Improving capital base

• Denominator Management Approach

• Reducing capital charge

• Combined Approach

• Phenomenal growth in Capital Funds over the last 5 years

• Of the 14 DCCBs, 12 had complied with 9% CRAR as on Mar ‘17.

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Study Recommendations

• The major observations/ suggestions for augmenting CRAR, thus

has been grouped under two major heads, viz

• Increasing Capital Funds: “ Numerator Management”

• Reducing Capital Charge on Assets: “Denominator Management”

• Some suggestions are subject to changes in existing policies.

Numerator Management[Increasing Capital Funds]

Permitting Reserve Funds as IPDIs

• Increasing Capital Funds through widening the avenues for Raising of “Innovative Perpetual Debt Instruments” (IPDI) [Tier I Capital]

• Many DCCBs/StCBs have not issued IPDIs to raise additional capital

• The various tiers of the co-operative structure statutorily maintain substantial deposits such as Reserve Fund [RF], Employees Provident fund [EPF], Staff Security deposit [SSD], etc., with their immediately higher tier

• While Reserve Fund is perpetually kept as deposit till their liquidation, EPF and SSD are partially utilised as and when the respective staff retires

• Such deposits, particularly the Reserve Fund [RF] of societies, can be considered to be kept as IPDI with the immediate higher tiers, with the permission of RCS. Eligible for Tier I Capital of DCCBs.

Considering Fluid Reserves as LTDs of DCCBs

• Increasing Capital Funds through Long Term (Subordinated) Deposits [LTDs]

• All PACS/ deposit accepting societies are required, as per the relevant State laws, to maintain a certain percentage of their deposits [usually 20%] as Fluid Reserves with their affiliated DCCBs

• At present, Fluid Reserves are invested as FDs with DCCBs.

• Societies may be permitted to invest their Fluid Reserves in LTDs issued by DCCBs

• This could be done at State Govt./ RCS level itself, as PACS are presently regulated by them

• This will be Win-Win for both DCCBs/ PACS

• PACS could get slightly higher Interest, while DCCBs could increase Tier II Capital.

Recognizing entire IFR balance as Tier I Capital

• RBI permits all Scheduled Commercial Banks, subject to certain

conditions, to treat the entire balance in the IFR as Tier I capital

• Cooperative Banks may also be extended this benefit

• Additionally, a preferential treatment could be extended to Coop. Banks by

allowing the entire balance in IFR to be reckoned as Tier I, without any conditions,

particularly as IFR is a below-the-line reserve

• This will provide two-way benefit to banks having IFR

• Increase in Tier-I Capital

• Greater headroom in augmenting Tier II.

Cir.

Augmenting Tier I Capital through Share Valuation

• Co-operative Banks have always issued shares to their members at face value, irrespective of when these shares are issued

• To provide a fair reflection of the worth of the shares of a DCB / StCB, there is a need to adopt a transparent Valuation method

• Considering the unique nature of the Co-operative structure, the most appropriate method would be the “Net Worth Valuation” method

• The Net Worth per share [{Share Capital + Reserves} / No. of Shares] will be a far more realistic estimate of how much the share of DCCBs/ StCBs is worth

• The excess of the share value over the face value could be considered as the Share Premium, which would form part of Tier I Capital Funds.

Augmenting Tier I Capital through Share Linkage

• Identifying such of those Societies which have a shortfall in share linkage in relation to their outstanding borrowings and mobilising balance share capital

• Re-visiting the monetary caps in share linkage for certain types of loans, imposed in some States

• Increasing the share linkage ratio wherever they are set very low [say 1% or 2%], for augmenting Share Capital.

• Consider stipulating a slab-wise share linkage based on quantum of loans given to individuals.

Creating CRAR Reserve

• StCBs/ DCCBs may be advised to create a new Reserve called “CRAR

Reserve” under the provisions of their byelaws as appropriation

from Profit

• This will help augment share capital and incidentally reduce

dividend flows.

Permission to issue “Co-operative Capital Bonds”

• StCBs/DCCBs may be permitted to float Co-operative Capital Bonds,

in the open market

• May be guaranteed either by the respective State Governments or by

NABARD [as a special case, with the approval of GoI]

• This could be in the lines of Uday Bonds

• Safety mechanism: banks to create Sinking Fund for redemption.

Special Reserve u/s. 36 (1) (viii) of IT Act, 1961

• The Co-operative Banks can take advantage of the extant RBI

guidelines which permit reckoning of outstanding amount in Special

Reserve created under

• Sec. 36(1) (viii) / 36 (1) (vii) of the Income Tax Act, 1961

….. as Tier I Capital

Denominator Management[Reducing Capital Charge]

Subvention Interest Receivable on KCC Loans

• Presently, Capital charge on Subvention Interest Receivable on KCC

Loans from GoI / State Govt. is 100%

• Recommendation is to treat such receivables on par with “Interest

due on Government Securities”, which attract “Zero” risk weight.

• This will unlock capital funds for new business development.

Capital Charge on KCC Loans

• KCC loans form a major chunk of the loan portfolio of most DCCBs

• Maximum interest cap of 7% applies on KCC loans upto Rs. 3 lakh

• Interest Incentive benefits are contingent on prompt repayment

• 3% from GoI, effective interest rate at borrower level is only 4%

• In many States, this 4% is also subsidised by the State Govt.

• Presently, Risk Weight on KCC Loans is 100%

• Recommendation is to reduce it to 50% or even less

• Most borrowers repay in time to avail the interest incentives.

Risk Weight on Jewel Loans

• RBI circular dated October 29, 2014 had permitted StCBs / DCCBs

to reckon a lower risk weight of 50% in respect of all Jewel Loans

upto Rs. 1 lakh issued to borrowers

• RBI may consider allowing this relaxation even for CC limits availed

by the DCCBs from StCBs / PACS from DCCBs in respect of

underlying jewel loans issued upto Rs. 1 lakh per borrower.

Exposure Norms for Housing purposes

• Presently, the exposure norms prescribed by RBI for Housing Loan

is 5% of total loan outstandings

• There is a case to re-look at this limit, atleast for loans given in

rural/semi-urban areas

• Housing Loans, besides being fully secured, also attracts a lower

capital charge of 50%.

Netting off of unencumbered deposits to loan outstandings

• Netting Off “Loans Outstanding” against Lien-marked deposits /

unencumbered Credit balances is now permitted

• DCCBs to take benefit of this relaxation to reduce capital charge

• Similarly, unencumbered deposits of DCCBs with StCBs may also be

permitted similar treatment, in the interest of equity. This will

reduce RWAs at StCB level.