Banks now resort to perpetual bond to boost capital base

Banks are now feeling the pressure to strengthen their capital base as the Bangladesh Bank has tightened its stance on bank capital requirements in line with Basel III compliance to cover unforeseen risks in the post-pandemic time.

The high capital requirement is driving banks to raise capital in a cost-effective way by adopting a new option – perpetual bond, which enables them to collect funds spending less than what other options cost in the form of stock dividend and right share.

Eight private commercial banks have recently announced to raise Tk3,600 crore through issuance of perpetual bonds, a new financial instrument that is growing in popularity in the banking sector.

A perpetual bond is fixed income security with no maturity date and it is often deemed as a type of equity, rather than debt.

The banks that are going to issue such a bond are City Bank, Mutual Trust Bank, Trust Bank, Jamuna Bank, One Bank, First Security Islami Bank, Social Islami Bank, and Exim Bank.

City Bank has already raised Tk400 crore through perpetual bonds, while others are in the process.

Mutual Trust will raise Tk400 crore through issuance of perpetual bonds, Trust Bank Tk400 crore, Jamuna Tk400 crore, One Bank Tk500 crore, First Security Islami Bank Tk600 crore, Social Islami Bank Tk500 crore, and Exim Bank Tk600 crore.

The City Bank Capital Resources Limited is working as the issue manager of all issuer banks.

The capital raised through perpetual bonds will be added to a bank's core capital, which is a component of Tier-1 capital.

Tier-1 capital is composed of core capital – the money a bank has stored to keep it functioning through all risky transactions, such as trading, investing and lending, it performs.

Banks are required to maintain a minimum of 8.5% Tier-1 capital of risk weighted assets to meet Basel III requirement and 18 banks have remained short of that till December last year.

Previously, stock dividends and rights issues were used for raising core capital or paid-up capital. The two options were expensive for banks as they have to offer higher stock dividends. The higher stock dividends dilute shares, causing a decline in earnings per share.

Moreover, the Bangladesh Bank has recently issued a dividend policy, requiring a higher capital base for a higher dividend. As a result, most banks are not capable of declaring higher dividends in line with the capital requirement.

In this situation, banks are preferring perpetual bonds as the third option to raise capital.

Such bonds are selling through private placement taking approval from the Bangladesh Securities and Exchange Commission.

Banks are preferring to invest in such bonds as the offered interest rate is above 9%, which is a better return, rather than risky lending at 9% to the private sector, say industry insiders.

The main feature of a perpetual bond is that it has no maturity date when other bonds have a certain maturity period, said Ershad Hossain, managing director and chief executive officer of City Bank Capital.

There is no buyback option but an issuer can call back a bond after 10 years, while the tenure is 5 years in India, he said.

When the call-back tenure of a bond is less, it becomes more attractive, Ershad added.

The Bangladesh Securities and Exchange Commission (BSEC) is working on listing the bond on the stock market to give an exit to investors, he informed.

He said the concept of Basel III compliant perpetual bond was conceived after the financial crisis in 2008. But, in Bangladesh, banks are now raising capital through the instrument as net margin of interest rate has declined, and high default loans plus balance sheets need to be expanded.

Mirza Elias Uddin Ahmed, managing director of Jamuna Bank, said banks are preferring to invest in perpetual bonds, considering a short-term risk-free investment. But there is a risk of loss too.

Explaining the risk factors, he said individuals cannot invest in such a bond with no exit. Only institutional investors, mostly banks, are investing in it but as there is no maturity date, the investment will be locked there for a long time until bonds get listed.

Moreover, when bonds are listed, trading prices may go down if public awareness does not grow about the bond market by that time. As a result, if investors want to come out of the investment, they may need to sell at a price lower than the purchase rate.

The interest rate of such bonds should be higher than the market average as the exit option is limited in such an investment, Mirza Elias opined.

But the interest rate of such bonds is being offered at 9% to 10% when the lending rate is also 9%, he said.

If the lending rate goes high anytime, investors will not be interested in investing in perpetual bonds, he explained.

Another risk factor is that banks are now investing their idle money in such bonds but as there is no maturity date of such investment, it might create liquidity crisis anytime, he said.

According to Basel III regulations, banks were supposed to maintain a minimum CAR (Capital Adequacy Ratio), also known as capital-to-risk weighted assets ratio, which is used to protect depositors, of 12.5% by 2019.

The industry's average CAR stood at 11.64% at the end of December last year, according to Bangladesh Bank data.

Moreover, in the new dividend policy, banks require to maintain at least 15% CAR to announce the highest 30% of dividends.

Only 12 banks maintained 15% CAR as of December last year of which some are likely to drop from the level as default loans have been assumed to rise significantly this year under the post-pandemic effects, say industry insiders.

Although the deadline for Basel III implementation ended in 2019, the Bangladesh Bank did not take any actions or gave any instruction even in one year to the banks and the banks also did not implement it.

According to the Bank Company Act, if banks fail to maintain regulatory capital requirements, the central bank can suspend fresh deposit collection, fresh lending, or impose financial penalty.