A framework providing multiple capital raising options for banks, including tier III capital, is likely to be detailed by the Reserve Bank of India [Get Quote] in the mid-term review of its 2005-06 monetary policy.

The urgency for clearly laying down new capital raising options has been prompted by the Basel II norms, which are a revised set of guidelines requiring banks to allocate capital more efficiently for credit and market risk and also for newly introduced operational risk.

The tier III instruments would be subordinated bonds of two-year maturity and provide the capital for market risks. Primary dealers in government securities are allowed to raise capital through this route.

The RBI draft guidelines on implementation of the Basel II capital adequacy norms do not elaborate on tier III bonds, but the Basel Committee on Banking Supervision has given discretion to regulators to include tier III capital, which along with tier II capital will be within the overall cap of 100 per cent of tier I capital.

In a research paper on banking, rating agency CARE said the subordinated bonds classified as tier III would have a clause which stipulates that neither interest nor principal, even at maturity, may be paid if such payment means that the bank falls below or remains below minimum capital requirement.

Debt servicing on such instruments hence will not be influenced by the availability of cash flows but also by the adequacy of tier I capital, and hence investors may seek extra premium in pricing such instruments.

The RBI recently allowed banks to treat their entire balances in investment fluctuation reserves, as tier I capital and RBI executive director Usha Thorat recently said amendment to the Banking Regulation Act is under consideration to enable banks to issue preference capital.

She had also stated that RBI is actively working on various capital raising options in view of implementation of Basel II norms from March 2007.

Apart from providing options to consider certain preference capital as Tier I, the other instruments that could be allowed are golden shares, fully convertible debentures as Tier I capital.

The various options would be of great help for public sector banks, as the government has set a floor of 51 per cent for its stake in PSBs. The government's stakes in some banks have neared the 51 per cent floor and will reach closer to the mark in many more soon as banks raise more equity capital.

Golden shares would be ideal for PSBs as it is a form of special rights, which could entitle the government to have veto rights over major dispositions of assets, a change of control, mergers or other major corporate changes.