Structuring the Yes Bank rescue

I have been trying to wrap my head around the Reserve Bank of India’s draft scheme of reconstruction of the Yes Bank Ltd under which the government owned State Bank of India (SBI) intends to rescue Yes Bank by picking up a minority equity stake without first wiping out the equity shareholders. It is very hard to make a good estimate of the value of Yes Bank without a highly intrusive due diligence for which there is no time now. However, the working assumption has to be that while the deposits and senior debt are hopefully not yet impaired, the equity and junior debt could conceivably turn out to be worthless. Any rescuer would therefore legitimately demand that its capital infusion be senior to existing equity.

The obvious solution of using preference shares is not available because:

• Under the Basel III framework, preference shares do not count for the most important CET1 (Common Equity Tier 1).

• The Companies Act 2013 does not allow the issue of perpetual preference shares, and instruments that are not perpetual do not count even for AT1 (Additional Tier 1) capital under Basel III.

The next best solution would be to first wipe out the existing equity shareholders and then compensate them in one of the following ways:

• Issue warrants to the existing shareholders to buy the new shares at the same price as SBI. Since SBI proposes to inject Rs 25 billion for a 49% stake, the warrants could be designed to allow existing shareholders to buy 51% for Rs 25-26 billion at any time during the next five years (if necessary, the strike price of the warrant could increase at 10-20% every year). This would have the additional advantage of improving the capital adequacy of Yes Bank.

• Existing shareholders could be given an option to buy out (a part of) SBI’s stake anytime during the next three years at a price that guarantees SBI an IRR (internal rate of return) of 30-40%.

• Existing shareholders could be given Contingent Value Rights that entitle the shareholders to receive new equity shares at the end of five years if the realized losses on the existing assets is below a specified threshold. The threshold could be set at a level that would imply an acceptable level of CET1 today.

To my mind, there are three compelling arguments for wiping out the existing shareholders:

1. This protects the interests of the taxpayer who is indirectly paying for the bailout because the rescuer is a public sector bank.

2. It avoids the counter intuitive outcome that Yes Bank’s AT1 bonds are wiped out, but the share capital is left intact.

3. It would strengthen Pillar 3 of the Basel framework which aims to promote market discipline as an integral element of bank regulation. I complained a year and a half ago that the quiescent shareholders of Yes Bank had failed to discipline the management. It would be a good idea to send a clear signal to the shareholders that if they are too quiescent, they stand to lose everything.

Exotic financial instruments have a bad name these days, but as I wrote seven years ago, they have proved invaluable in designing rescue packages for the financial sector.

Posted at 8:16 pm IST on Sat, 7 Mar 2020         permanent link

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