The country's listed public sector banks are in a real bind.

While the tremendous credit growth (non-food credit for the entire industry grew by Rs 2,14,000 crore (Rs 2,140 billion), or 26.5 per cent in 2004-05, which makes it the second-highest in the last 55 years) means the banks need a lot more capital to maintain the mandated capital adequacy ratio (CAR), banks cannot raise capital through the market since that would mean diluting the government shareholding which, in many cases, is near around 51 per cent already.

In addition, with the introduction of the new Basel II norms, even the current CAR levels will go down.

Last year's credit momentum is continuing, and till June 10, the banking system's non-food credit grew by Rs 53,471 crore (Rs 534.71 billion), as compared to Rs 20,018 crore (Rs 200.18 billion) in the corresponding period of last year.

In order to carry on with the current pace of lending, banks need to have a minimum CAR of 9 per cent  --  that is, for each additional Rs 100 of loans, the banks need fresh capital of Rs 9.

In addition, rolling out of Basel II norms will shave off a bank's existing CAR by around 1.5-2 percentage points as banks will have to re-rate their loan assets and, depending on the risk an asset carries, the capital cover (or risk weightage in banking parlance) could be higher than 100 per cent.

Given the current CAR levels of banks, this means most banks will need additional capital even without increasing their loan portfolios.

Among the listed nationalised banks, Oriental Bank of Commerce [Get Quote] and Dena Bank [Get Quote] will be the most affected as they have already brought down the government stake in them to almost 51 per cent through successive public floats.

This means that these two banks will not be allowed to enter the market to raise fresh capital unless the government decides to bring down its stake to below 51 per cent.

Two more banks are in a similar bind. These are Vijaya Bank [Get Quote] and Allahabad Bank [Get Quote]. The government stake in Vijaya Bank is 53.87 per cent and 55.23 per cent in the case of Allahabad Bank.

For all practical purposes, Punjab National Bank [Get Quote] and Corporation Bank [Get Quote] have very little leeway either to raise fresh money from the market as the government stake in these banks is around 57 per cent.

Since these banks are not in a position to raise capital from the market, the only choice they have is to post handsome profits and raise their net worth. This, however, is easier said than done.

Collectively, the listed PSU banks posted a profit of Rs 12,800 crore (Rs 128 billion) in 2004-05. As the average dividend payout is about 25 per cent, they can plough back a little over Rs 9,000 crore (Rs 90 billion) into their reserves, which would allow them to theoretically grant fresh loans of up to around Rs 1,00,000 crore (Rs 1,000 billion).

Given the current pace of loan growth, that's clearly not enough considering that these listed PSU banks account for around 70-75 per cent of all loan growth in the country.

Given their constraints, clearly banks then need to explore other ways of raising capital. The most popular way of shoring up the capital base is floatation of long-term subordinate debt.

However, this option has its limitations as subordinate debt or long-term Tier II bonds cannot be more than 50 per cent of a bank's Tier I capital that consists of paid-up capital, statutory reserves and other disclosed reserves.

Tier II capital includes revaluation of reserves, cumulative preference shares, investment fluctuation reserves and subordinate debt besides other hybrid capital instruments.

Technically, the size of the Tier II capital could be as much as that of Tier I but under no circumstance can the subordinate debt be more than the Tier I capital. Most of these banks have little leeway to raise subordinate debt.

Nor is a rights issue possible (which will keep the level of government equity constant) as the government is not keen on pumping in fresh money into these banks. It has pumped in over Rs 20,000 crore (Rs 200 billion) into the public sector banking industry over the last decade to shore up its capital base.

Little wonder then that both the government as well as the Reserve Bank of India [Get Quote] have been talking about allowing banks to raise preference capital. Section 12 of the Banking Regulation Act 1949 prohibits banks from issuing preference shares.

If the banks are to be allowed to issue preference shares, the government will have to amend the Banking Regulation Act, 1949. Section 53 of the Act allows the Centre to issue a notification exempting banks from following the provisions of Section 12.

However, the problem is that preference shares can only be treated as part of Tier II capital and hence the maximum amount that can be raised through this route is restricted.

Any instrument which can be redeemed at the will be of the investor cannot form part of Tier I capital of a bank.

So, the choice before the regulator is limited. It will have to allow the banks to go for innovative instruments to augment their capital base. In fact, the Basel Committee in October 1998 had decided that innovative capital instruments could account for as much as 15 per cent of a bank's Tier I capital.

The Financial Services Authority (FSA) in the UK as well as the Federal Reserve in the US have allowed their banks to treat such instruments as part of their Tier I capital.

Primarily, there are three such instruments: non-cumulative perpetual preferred shares, cumulative perpetual preferred shares by banks as well as special purpose vehicles of banks and trust preferred securities that are a hybrid of corporate debt and preference shares.

Banks in the United Kingdom and the United States have been allowed by their regulators to use perpetual non-cumulative preference shares as part of their core capital.

Going by the recommendations of the Basel Committee, all instruments which feature in the Tier I capital of bank should be non-cumulative, permanent in nature, and callable by the issuer only after a minimum period of five years with supervisory approval and under the condition that it will be replaced with capital unless the supervisor feels that the particular bank is adequately capitalised.

The committee has also said that the main feature of such an instrument must be easily understood and publicly disclosed.

The RBI should not have any reservation in allowing listed nationalised banks to float innovative capital instruments in a transparent manner in accordance with the Basel norms.

There will not be any dearth of takers for these instruments and corporations will be only too happy to lap up preference shares as dividend income does not attract tax.

This could be the best way to tackle the capital issue till such time the government makes up its mind on lowering its stake to below 51 per cent.