Write-off of Lakshmi Vilas Bank's debt to sting small lenders

India’s smaller banks will likely face higher funding costs and reduced investor appetite for their bonds just as non-performing loans spread, after the central bank moved to write off debt of an ailing lender.

The Reserve Bank of India on late Thursday said Rs3.18 billion ($43 million) of Tier 2 bonds of Lakshmi Vilas Bank Ltd. will be fully written down as DBS Group Holdings Ltd. acquires the lender. The announcement comes as a surprise after the RBI-appointed administrator said last week DBS would take over all obligations, including bonds.

“Financing costs may inch up and the appetite shall be lower especially for the lower-rated private and small finance banks,” said Ajay Manglunia, managing director and head at JM Financial Products Ltd. “Such lenders will have to rely more on equity raise as investors shall be a bit more skeptical to take risk now.”

Weakening demand for bank bonds will add to pressure on lenders already saddled with one of the world’s worst bad debt piles. Banks also need to boost their capital in anticipation of more soured loans as the fallout of the pandemic batters businesses.