PFC’s Buyout Of REC Will Hurt Its Capital Buffers

India’s plan to ask Power Finance Corporation Ltd. to buy the government’s 52 percent stake in state-run peer REC Ltd. will help it narrow the budget gap. But that will also bring the PFC’s mandatory capital buffers below the regulatory level.

The cabinet approved the sale today, Finance Minister Arun Jaitley said after a meeting. The modalities will be worked out by a committee comprising him, secretaries of the departments involved and Union Minister Nitin Gadkari, he said.

The Economic Times first reported that the government is now considering a proposal to make PFC acquire REC in a Rs 14,000-crore deal. BloombergQuint hasn't be able to independently verify the the number. At the current market prices, the government’s stake in REC is worth around Rs 11,000 crore.

The deal will bring the government closer to its Rs 80,000-crore disinvestment target for the ongoing financial year—it has so far raised Rs 32,737 crore. That would mirror Oil and Natural Gas Corporation Ltd.’s acquisition of the government’s stake in Hindustan Petroleum Corporation Ltd., which had helped Prime Minister Narendra Modi’s administration exceed its divestment target in the last financial year.

The only difference being that this time two lenders are involved. So the buyout will be subject to the Reserve Bank of India’s capital adequacy or minimum buffers levels.

PFC’s tier I capital adequacy ratio—the minimum buffer needed based on the risk level of loans—stood at 16.98 percent and overall CAR at 19.99 percent as of March against the requirement of 10 percent and 15 percent, respectively, according to CARE Ratings’ December report. This declined marginally after adoption of new Indian Accounting Standards. The tier I buffer was 14.91 percent and overall level at 17.91 percent as of September, CARE said.

PFC had a net worth of over Rs 38,000 crore at the end of September 2018, according to filings. It’s expected to invest Rs 14,000 crore in REC, which is in excess of 10 percent of its net worth (Rs 3,800 crore).

When a bank or a non-bank lender invests more than 10 percent of its net worth in a single entity, the amount in excess of that 10 percent is knocked off from its net worth while calculating the capital adequacy ratio, according to the regulatory rules.

So while REC will become a subsidiary, PFC’s net worth will be reduced by Rs 10,200 crore (Rs 14,000 – Rs 3,800 crore). Since credit exposure remains the same, capital adequacy falls.

The tier-I CAR for PFC will fall below the required 10 percent after the deal, two banking analysts told BloombergQuint on the condition of anonymity, as they are not authorised to speak to the media. PFC will have to seek the RBI’s exemption on capital adequacy norms or raise additional capital from the market, the second person said.

The other way out is a merger between PFC and REC. That may not have any impact on PFC’s capital situation as the majority ownership remains with the government and the merged entity will have a diversified portfolio, said the person cited earlier.

“In case of a merger, there may be certain operational synergies as many of the borrowers of the two companies are common, thereby saving upon credit appraisal and due diligence costs,” Anil Gupta, head-financial sector ratings at ICRA, said. “However, this will not be significant as operational costs are not very high for these companies.”

REC’s Chairman and Managing Director PV Ramesh had earlier told BloombergQuint that the company prefers a merger with PFC rather than just an equity transaction.

Sambitosh Mohapatra, partner (power and utilities), PwC India, sees positives from such a merger and creation of significant shareholder value over time given the possibility of size and scale, ability to invest in process, technology and people.

But for the government, that means no immediate cash to boost its divestment proceeds.