Amidst the general rising trend in bank profits, including many public sector banks, the one thing missing is this: there is almost no move to raise funds through equity. 

Many banks, from State Bank of India (SBI) downwards, have proposed to raise additional quasi-equity in the form of additional Tier-1 bonds (AT1). But, as the recent lukewarm response to the SBI offering of AT1 showed, the investor is clearly looking for something more than long-term yields from investment in banks.

SBI offered Rs 10,000 crore of AT1 bonds, and accepted Rs 3,101 crore at 8.1 per cent against a total bid amount of Rs 5,920 crore.  

If there is any bank which is almost a substitute for the sovereign, it is State Bank of India. It is a bank which will never be privatised, can never be allowed to default, and will never be anything less than sovereign in terms of perception.

So, if SBI cannot raise quasi-equity from investors, clearly what the market is telling us is something else.

There is a clear case for public sector banks to raise pure equity, and not near-equity like AT1, since the investor is not looking merely for assured returns from a segment of the banking sector which is not as nimble as private sector banks.

Private banks have the advantage of high returns on equity, and thus can fund most of their additional capital needs from retained profits. In the case of public sector banks, there is surely a suspicion that future growth will need equity dilution, especially when the quality of margins or profits drops. 

Since public sector banks are always going to be at a discount to well-run private sector banks, the tendency is to avoid equity dilution now by going in for bonds that look as good as equity for calculating Tier 1 capital.

This is not a good way of looking at the issue. Equity is risk capital, and despite the prospects of dilution when equity raising happens in large dollops, this is actually the best way to fund public sector banks. 

Two reasons why. One, subscriptions are guaranteed, since the majority owner can always take up the slack. After all, when these banks were under water, it was the government that injected equity in them.

So why not when they are healthy? And two, equity dilution is a better alternative to incurring debt, which thins down net interest margins, and depresses equity prices anyway.

The Finance Ministry under Nirmala Sitharaman must ask all public sector banks that cannot raise their share of retained profits (ie, net worth) to raise more from rights issues, even if these are at a steep discount to market prices.

Investors are likely to buy equity that is underpriced, and even if they don’t, the government gets to raise its stake at low cost, which it can then offload via smaller offers for sale to qualified institutional buyers.

The time to do this is now, when the equity markets are still buoyant, and not when they fall into a negative trend.

The case for discounted public sector rights issues is strong, especially where their book value is relatively low. These include large banks like Bank of India, which are outside the list of banks chosen for consolidation, and could hence be candidates for strategic sale at some point.

A deep-discounted rights issue should do well and strengthen balance-sheets of all such banks. It should work even for banks that were merged a few years ago, and which are part of the government’s strategic holdings in the banking sector. Punjab National Bank is one such bank. Its market price is far below book value.