SINGAPORE (S&P Global Ratings) March 9, 2020--The Indian government is working with the State Bank of India (SBI) to inject capital into Yes Bank Ltd., a troubled private-sector bank with 1.8% of the country's bank deposits (as of March 31, 2019). S&P Global Ratings believes that quick resolution of Yes Bank's insolvency will keep India bank-sector contagion at bay, though it poses pain for investors in bank hybrid securities. As credit markets tighten, we also see a possibility of wider economic pain in the country.

The government had earlier put Yes Bank under moratorium restricting the bank's operations, and capping deposit withdrawals at Indian rupee 50,000. This gives the government time to rescue the weak lender. As per the draft reconstruction scheme, SBI will infuse capital into the bank and acquire up to a 49% stake.

We view the Indian government as highly supportive of the banking sector. The Indian government has consistently supported weak commercial banks by promoting the merger of distressed institutions with stronger lenders. The government has historically not allowed commercial banks to fail and has in the past swiftly stepped in to address trouble.

The current weak economic and high-fear global investment environment, in our view, has prompted the government to support the recovery of Yes Bank. However, in better times, we believe the government would think twice about pushing such a package for relatively small banks.

SBI will own a minimum of 26% of Yes Bank for the next three years. SBI's ownership should give confidence to depositors and lenders about the bank's solvency.

We expect the risk premiums for additional Tier 1 (AT1) instruments of private sector banks in India to spike in the aftermath of the Yes Bank bailout. As per the proposed draft reconstruction scheme, Yes Bank's AT1s will be entirely and permanently written down. The write-off of AT1s is in line with out view that these instruments will absorb losses at private sector banks, unlike public sector banks.

The AT1s, a hybrid instrument designed to protect banks during distress, will absorb the maximum loss. This may increase the risk premium on all Indian bank sector Tier 2 subordinated bonds.

In our opinion, any delay in, or uncertainty about, the implementation of the resolution plan may roil markets. News reports suggest that AT1 investors may take legal action, which may delay the resolution plan.

The events follow Yes Bank's failure to raise capital to address loan losses, sparking a withdrawal of deposits. India's central bank has highlighted serious governance issues at Yes Bank, lapses that have contributed to the institution's steady decline in recent years.

In our view, India's financial sector broadly needs to raise governance standards and restore trust. In the past few years, regulators have identified many governance shortcomings among Indian lenders, most recently at Punjab and Maharashtra Cooperative Bank Ltd. (see "India's Cooperative Bank Troubles Reflect Governance Deficit," Oct. 7, 2019).

The central bank's assessment of nonperforming loans for a number of banks was higher than lenders' own assessments, suggesting transparency was poor at the institutions.

Contagion Risk

If Yes Bank's resolution process is prolonged, there is a risk the broader banking environment may take a hit. This may raise investors' perception of credit risk in the system, tightening funding. We have highlighted the rising contagion risk in India since October 2019 (see "Indian Financial Sector Braces For Fat Contagion Tail Risk," Oct. 23, 2019).

Many mutual funds hold Yes Bank securities, including subordinated debt and AT1s. A depreciation in the value of these instruments would hurt credit funds, potentially triggering capital outflows. This could widen spreads and drain the credit available to lower-rated entities.

The uncertainty may engulf weak financial-sector entities, including non-bank finance companies or private-sector banks.

Companies with marginal credit profiles, perceived governance issues, and aggressive risk appetites are particularly vulnerable. These could suffer from extended risk aversion, resulting in rising borrowing costs.

Finance companies holding AT1s in their treasury investments will see credit losses.

We don't see any major adverse effect for the public-sector banks as market participants take confidence in their state ownership and the repeated demonstrations of government support for the institutions. Some public sector banks may benefit from a flight to quality. Better quality private institutions, such as HDFC Bank Ltd., may also benefit given their good asset quality, management, governance, profitability, and capitalization.

The speed of the government action will be critical to provide clarity. In the past cases of bank failures--such as the collapse of Global Trust Bank Ltd., Nedungadi Bank Ltd., United Western Bank Ltd., Bank of Rajasthan Ltd. and Sangli Bank Ltd.--we have seen swift action that nipped contagion in the bud.