By Una Galani

MUMBAI, May 25 (Reuters Breakingviews) - India's stressed banks are piling on risks. The country’s lenders have flocked to issue contingent bonds that can be written down if capital falls short. But an implicit government guarantee of public sector banks means few investors expect such clauses will ever be triggered. If one bank slips, it is easy to imagine a system-wide freakout.

Issuance of so-called "Additional Tier 1" bonds is rising rapidly in India. Banks sold almost $6 billion worth of these securities in the financial year to March, compared with almost nothing in the previous twelve months. State-backed lenders issued almost three-quarters of the bonds by value.

In theory, the bonds should act as shock absorbers when banks suffer losses – first by suspending dividend payments, and then replenishing capital. The problem is that many investors assume the authorities will never let that happen.

That belief is reflected in local ratings. For example, India Ratings assigned a double-A plus rating to a recent contingent issue by HDFC Bank, the country's largest private sector lender. HDFC’s common equity Tier 1 capital ratio of 12.8 percent would have to drop by more than half in order to trigger a writedown. But the same agency gave a double-A rating to an issue by state peer Union Bank, which has a capital ratio of just 7.7 percent.

India’s central bank has aided the complacency. In February, it relaxed rules to enable at least three public sector lenders to continue paying coupons on their bonds. Even so, Credit Suisse thinks at least two small state banks will have to cancel coupons in the coming quarters.

In theory, missed coupons and writedowns should be signs the bonds are working as designed. However, the risk is that investors – including insurers and pension funds – respond by fleeing the asset class. At worst, the loss of confidence might lead to a flight of deposits. Though that sounds extreme, Indian state banks have a reputation for always paying their dues, so no one really knows how the market would react. Either way, the assumption that the state will support instruments designed to enforce market discipline sets the scene for trouble.

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CONTEXT NEWS

- HDFC Bank, India’s largest private sector bank, said on May 12 that it raised 80 billion rupees ($1.3 billion) from Basel III-compliant Additional Tier 1 bonds.

- The bonds, which carry a coupon of 8.85 percent, may be written down if the bank’s common equity Tier 1 capital ratio falls below 5.5 percent before March 31, 2019 and 6.125 percent thereafter. HDFC had a CET1 ratio of 12.85 percent at the end of March.

- The issuance of so-called AT1 perpetual bonds is rising in India. Only $23 million was raised through such instruments in the financial year to March 2016, according to a report published by the Reserve Bank of India in August 2016. Fitch estimates that Indian banks issued up to $6 billion of such instruments in the following year to March 2017.

- In February, India's central bank revised rules that threatened to force at least three public sector banks to miss coupon payments. The previous rules only allowed banks to pay coupons out of their current-year earnings and so-called "revenue reserves" - an account kept for future funding needs when profit is low.

- The new rules allow banks to pay coupons out of their statutory reserves.

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(Editing by Peter Thal Larsen and Kathy Gao)

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