The rules hurt demand for such paper and make it more expensive for banks to raise capital.

"Funding need for banks will rise and changing the valuation would be beneficial as it will increase investor base," said Ajay Manglunia, managing director and head of the investment grade group at JM Financial.

The Securities and Exchange Board of India (SEBI) changed the way additional tier I (AT-1) bonds were valued in March 2021, after YES Bank completely wrote down such bonds in 2020, as a part of a state-led restructuring plan.

Following this, the markets regulator asked mutual funds to value perpetual bonds as 10-year papers until March 2022 and 30-year papers until March 2023 and 100-year paper thereafter.

The recommendation to change it back, which was made to the National Financial Reporting Authority (NFRA), is in line with the international practice, a government official said requesting anonymity, as they are not authorised to speak to media.

They added that the recommendation was currently under review with the NFRA, a regulator that oversees auditing, which will submit its views to a panel of top regulators.

A final decision will only be taken thereafter, the sources mentioned above added.

The change in valuation norms led to a drop in such bonds issued by Indian lenders to around 137 billion rupees ($1.65 billion) in the current fiscal, from a peak of 430 billion rupees issued in 2016-17, according to ICRA.

Earlier this month, the country's largest lender SBI raised funds through perpetual bonds, with a 10-year call option at 8.34% coupon, around 70 basis points (bps) over the 10-year AAA-rated corporate bond yield.

The spread between the two used to be around 30-40 bps in 2019 before the YES Bank episode, and if the norm is changed back to the way it was, spreads may fall to around 50 bps, traders said.

Higher spreads indicate investors are demanding more premium for investing in perpetual bonds, making them expensive for banks.

"...If the valuation of the bond shifts from deemed 100-year maturity to call option as is the market practice, mutual funds are likely to participate in a significant way," said Sandeep Bagla, CEO at Trust Mutual Fund.

($1 = 83.1609 Indian rupees)

(Reporting by Dharamraj Dhutia, Nikunj Ohri and Jayshree P Upadhyay; Editing by Janane Venkatraman)

By Dharamraj Dhutia, Nikunj Ohri and Jayshree P Upadhyay