Capital Ratios After the Inspection Shortfall
Deccan Meridian Bank reports risk-weighted assets of ₹22,000 crore as at 31 March 2026. Its capital is: paid-up equity, share premium and reserves eligible as Common Equity Tier 1 of ₹1,800 crore; AT1 bonds of ₹150 crore; and Tier 2 bonds of ₹120 crore. During the RBI's annual inspection, the supervisor finds that ₹200 crore of provisioning on two large accounts should have been made in the year ended 31 March 2026 but was not, and directs the bank to debit the same. The board is presented with three options for restoring the ratios by September 2026: a ₹500 crore qualified institutional placement; a ₹250 crore AT1 issue at 9.50 per cent; or slowing loan growth to reduce risk-weighted assets by ₹2,500 crore. The CFO favours the AT1 because it is 'cheaper than equity dilution and does not dilute the promoters'. No tax effect is to be considered.
1. Compute the CET1, Tier 1 and total capital ratios before and after the RBI's provisioning adjustment, and identify the binding constraint.
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Regulatory benchmarks (RBI Basel III): CET1 5.5% + capital conservation buffer 2.5% = 8.0%; Tier 1 7.0% + 2.5% = 9.5%; total capital 9.0% + 2.5% = 11.5% of risk-weighted assets.
Before the inspection adjustment (RWA ₹22,000 crore):
- CET1 = 1,800/22,000 = 8.18% - surplus over 8.0% is only ₹40 crore
- Tier 1 = (1,800 + 150)/22,000 = 8.86% - short by ₹140 crore
- Total = (1,800 + 150 + 120)/22,000 = 9.41% - short by ₹460 crore
After debiting ₹200 crore of provisions to CET1:
- CET1 = 1,600/22,000 = 7.27% - short of 8.0% by ₹160 crore
- Tier 1 = 1,750/22,000 = 7.95% - short of 9.5% by ₹340 crore
- Total = 1,870/22,000 = 8.50% - below even the 9.0% minimum, and short of 11.5% by ₹660 crore
Binding constraint. Total capital at ₹660 crore is the largest gap, but the breach of the 9 per cent minimum and of the CET1 requirement means the bank cannot fix this with hybrid instruments. Only CET1 - equity, retained earnings or lower RWA - improves all three ratios. AT1 improves Tier 1 and total capital but leaves CET1 at 7.27 per cent, and Tier 2 paper counts neither in Tier 1 nor in CET1.
2. Evaluate the three options with numbers and recommend a workable plan.
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Test each option against the ₹660 crore total shortfall and the 8.0 per cent CET1 floor.
- ₹500 crore QIP. CET1 ₹2,100 crore (9.55%), Tier 1 ₹2,250 crore (10.23%), total ₹2,370 crore (10.77%). All ratios improve and the CET1 breach is fixed, but total capital is still ₹160 crore short of 11.5 per cent. The QIP alone is not sufficient, but it is the only option that fixes CET1.
- ₹250 crore AT1 at 9.50 per cent. Tier 1 becomes ₹2,000 crore (9.09%) and total ₹2,120 crore (9.64%), with CET1 unchanged at 7.27 per cent. The bank remains in breach on all three counts; the annual coupon of ₹23.75 crore is payable only out of distributable profit and only with RBI approval while the bank is below the minimums. The CFO's argument confuses Tier 1 with CET1: AT1 absorbs losses at the point of non-viability, not while the bank is a going concern.
- Cutting RWA by ₹2,500 crore. With RWA of ₹19,500 crore: CET1 8.21%, Tier 1 8.97%, total 9.59%. CET1 and the 9 per cent floor are met, but Tier 1 and total capital are still short, and the RWA reduction also cuts future income, weakening internal capital generation.
Workable combination. A ₹500 crore QIP plus about ₹1,500 crore of RWA reduction gives RWA of ₹20,500 crore and total capital of ₹2,370 crore = 11.56%, with Tier 1 at 10.98% and CET1 at 10.24% - compliant on all three. Equivalently, a ₹660 crore equity raise solves it without shrinking the book. And the ₹200 crore provision should not be treated as a one-off: the plan needs a buffer for the next inspection cycle.
3. What regulatory consequences follow a failure to restore the ratios, and how should the capital plan be sequenced?
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Consequences. Falling below the 9 per cent minimum and the CET1 requirement exposes the bank to the RBI's prompt corrective action framework, with restrictions on dividend, branch expansion, capital distribution and management compensation, and to closer supervisory monitoring. The bank must submit a time-bound capital restoration plan, and no dividend can be declared while the capital conservation buffer requirement is unmet.
Sequencing the plan.
- Confirm the ₹200 crore debit by board resolution and restate the ratios; do not let the audit committee sign off on the earlier figures.
- Take the equity route first. A rights issue to existing shareholders is usually faster and cheaper than a QIP, and a promoter commitment improves the QIP pricing if the market route is needed.
- Use AT1 and Tier 2 only to top up Tier 1 and total capital to the 9.5/11.5 per cent targets once CET1 is comfortable. Any AT1 must satisfy the RBI's Basel III criteria - a point-of-non-viability trigger at CET1 of 5.5 per cent, conversion into equity, no step-up, and prior RBI approval - and may be called only with RBI approval and replacement by instruments of equal or better quality.
- Slow the growth of risk-weighted assets by re-pricing or exiting low-return corporate exposures, not by cutting retail and priority sector lending, which would create a different compliance problem.
- Strengthen internal capital generation. The ₹200 crore provision is a symptom of weak credit monitoring, so the early-warning (SMA) and review framework needs tightening alongside the capital plan.