Bank sub-debts write downs within regulatory boundaries outlined by Basel 3
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Rashaad Tayob, multi-counsel Portfolio Manager of the Nedgroup Investments Stable Fund and a member of the Foord investment team, says regardless of the noise in the media following the banking collapses, the subordinated debt written down by the banks has fulfilled the role that it was intended to and is within regulatory allowances.
“Following the 2008 financial crisis bailouts, central banks wanted loss absorbing debt instruments and that is essentially what has happened. Sub-debt issuances are typically used by banks to meet regulatory capital requirements. Regulators require banks to maintain a certain level of capital as a buffer against potential losses. Sub-debt counts towards this regulatory capital requirement because it can absorb losses,” he says.
Basel 3 rules allow for sub-ordinated debt to be written off
“The issue is that, within the requirements of Basel 3, the capital structure has essentially been inverted, putting fixed-income investors first in line to take losses – ahead of equity holders. We saw this in the case of Credit Suisse. However, regardless of the fact that many people disagreed with this structure, and although many people who took losses as a result will complain, it was all quite valid and within the capital structures defined by the regulations,” explains Tayob.
Before Basel 3, Tayob says the capital structure was respected. For example, if a bank was under financial strain, preference shares would stop getting their dividends until the bank was back on its feet. However, once the bank recovered, they would reinstate the preferential shareholder dividends before paying normal dividends. “So you couldn’t be written off as a preferential shareholder – whereas with AT1 debt this is now possible,” he says.
“There are a lot of technicalities around the South African case and around how our notes would be written off, but essentially, South Africa doesn’t have a formal resolution regime in place. As such, AT1 and T2 bonds had to be issued with contractual loss absorption clauses and can be bailed in before shareholders. The contractual wording is clear. Tier 1 and Tier 2 sub-ordinated debt can be written off in full and it will not be classified as a default,” he says.
Risk of perpetual instruments
Tayob says that there is a risk of ending up with a much longer instrument for anyone holding sub-ordinated debt issued in the last two years, especially anything below Jibar plus 400. Subordinated bonds are issued as 10- year or perpetual instruments with 5-year call dates. To date they have always been called, but if investors’ perception of write-off risk changes then spreads could widen. “If new debt has to be issued at much more expensive levels regulators will be very hesitant to allow these instruments to be called at the 5-year point” he says.
Ratings on sub-ordinated debt and the accounting ratios on the banks can be misleading for holders of sub-ordinated debt. “When you give a company a loan, there is a lot of flexibility over how you mark that loan down and how you take that loss. There are also ways for banks to not recognise losses – by rolling over the loans for example. That’s why Silicon Valley Bank and Credit Suisse capital ratios looked reasonable, even at the point that they failed,” says Tayob.
SA Banks are well capitalised but still vulnerable
South African banks are well capitalised and have good risk management, but the major risks will be economic stagnation in South Africa, and they are still vulnerable to a loss of confidence.
Tayob says South African banks could use subordinated debt to recapitalise banks in the event that they become affected by a negative shock. “There will be very strong incentive to save the bank with these instruments rather than wind up the bank and cause substantial job-loss,” he says.
At the same time, Tayob says spreads in South Africa are way too narrow and a repricing is required.
The big question is whether Tier 1 bonds will become perpetual – which could occur if there is a trend amongst global banks not to call them.
“We will be monitoring the upcoming AT1 call dates closely. Meanwhile, we continue to be conservative, and we definitely see the risk of credit spreads widening in South Africa.”