On Sept. 20, 2021, S&P Global Ratings published a request for comment (RFC), "Request For Comment: Hybrid Capital Methodology For Multilateral Lending And Multilateral Insurance Institutions," proposing targeted changes to "Hybrid Capital: Methodology And Assumptions," July 1, 2019.

Following feedback from market participants, we finalized and published our criteria, "Hybrid Capital: Methodology And Assumptions," on March 2, 2022, having expanded the scope to incorporate considerations for hybrids issued by multilateral lending institutions (MLIs) and multilateral insurance institutions. Throughout this article we use MLI to refer to both types of institutions.

We'd like to thank investors, issuers, and other intermediaries who provided feedback. This RFC Process Summary provides an overview of the external written comments and certain other feedback we received from the market on the proposed criteria, the changes we made following the RFC period, and the rationale for those changes.

Written Comments Received From Market Participants That Led To Significant Analytical Changes To The Final Criteria

We did not receive any external written comments from market participants that led to significant analytical changes to the criteria.

Written Comments Received From Market Participants That Did Not Lead To Significant Analytical Changes To The Final Criteria

All except one of the comments agreed that hybrid capital can play a role in capital management for the MLI sector, although each of these comments recommended that the criteria should apply less stringent features than our RFC proposals for an MLI hybrid to be eligible for equity content. The other comment disagreed strongly with the concept of MLIs issuing hybrid capital.

Permanent loss-absorption features

The topic comments addressed most was the proposed permanent write-down or conversion feature if the issuing MLI draws down callable capital, and whether callable capital could be used to pay out on hybrids.

One commenter proposed that MLI hybrids should still be assigned equity content even if callable capital was able to pay off hybrid investors. They cited how hybrids would still be in line to absorb losses if members failed to provide callable capital. We agree, in that situation, the hybrids would be bearing losses and acting like capital.

We have maintained our proposed approach, however, because the inclusion of hybrids in our stand-alone credit profile (SACP) analysis means that we expect hybrids to absorb losses before callable capital--not at the same time, and not only in the event that callable capital does not arrive. For similar reasons, we have decided not to adopt one commenter's suggestion that the amount of any hybrid write-down should not exceed the value of callable capital that is drawn down.

Another comment suggested that potential double counting (whereby callable capital could be used to pay off hybrid investors) could be prevented by deducting from the amount of callable capital the value of the hybrids included in the risk-adjusted capital (RAC) ratio used when determining the SACP, while at the same time allowing MLI hybrids to receive equity credit without having a permanent write-down or conversion feature. The comment suggested that this would enable callable capital to be used to support hybrids while recognizing this explicitly in our metrics. We agree that this is a potential solution to double counting. We decided not to adopt it, however, because this would explicitly recognize hybrids as a partial replacement for callable capital and not as an additional enhancement to the balance sheet. For similar reasons, we decided not to adopt a proposal from a different commenter that equity content should still be possible if shareholders are able to decide whether callable capital funds can be used to pay out to hybrid investors.

A comment pointed out that some MLIs do not benefit from issuer credit rating (ICR) uplift due to callable capital and that they therefore can't have any double counting that would justify a permanent write-down feature. We agree that some MLIs don't receive callable capital uplift. Some don't receive uplift because the ratings on the governments that would provide the callable capital are not sufficiently high compared to the creditworthiness of the MLI. The MLI could become eligible for such uplift if it came under stress--for example, if the ICR on the MLI were to fall below the ICRs on relevant callable capital providers. However, our assessment of equity content focuses on the ability of a hybrid to absorb losses in a stress, so we have decided not to exempt such MLIs from the write-down/conversion features.

Some other MLIs don't receive uplift for callable capital because they don't have access to any. We have maintained the proposal that in these cases the write-down or conversion occurs before default on senior obligations. We consider this level of loss absorption in such a stress scenario to be appropriate for the hybrid to be assigned equity content.

Another comment agreed that callable capital should not be "used to pay out on the hybrids" but raised concerns that a permanent write-down feature was not consistent with the principle (seen in bank hybrids) that a creditor should not be worse off than in insolvency. We agree that permanent write-down features may make such hybrids less attractive to some investors, but we have decided to maintain the approach outlined in the RFC.

The permanent write-down would only take place if callable capital were to be drawn down--an event that has never happened in the sector and that typically can only occur to prevent the MLI from defaulting. The "no creditor worse off" principle used when looking at bank resolutions compares how creditors fare in a resolution to how they would have fared in a liquidation if no resolution had happened. We've looked at the callable capital drawdown as an event akin to a bank resolution, though arguably even more remote given that ICRs are, on average, higher for MLIs. If callable capital doesn't arrive, then we expect the MLI would default on senior bonds and hybrid investors would likely be wiped out in a liquidation (given that the paid-in capitalization of the MLI would have been eroded so significantly). We therefore don't consider that the write-down feature clearly disadvantages the hybrid investor versus a stress situation where callable capital doesn't arrive on the balance sheet.

The permanent nature of the write-down means that MLI hybrid investors lose out in full if callable capital is drawn down, while bank hybrid investors can, in theory, still benefit from a write-back or reinstatement of principal if a resolution goes well. However, there have not yet been any cases of a successful reinstatement of principal following a bank resolution.

Commenters provided several suggestions for financial considerations that could lead to a write-up of the principal--for example, based on IFRS net profit performance over a particular period, depending on the amount of paid-up equity versus losses in the period versus the call. We agree that these are alternatives to regulatory oversight, which could be based on independently audited financial metrics. But we still see these as inconsistent with the approach taken for banks, where any future write-back has to be fully discretionary and cannot be promised based on any individual metric.

One comment suggested that a write-back could be based on the same trigger that led to the write-down. If the trigger for the write-down would be a drawdown of callable capital, then the write-back trigger would need to be the repayment of all the callable capital that was drawn down (as suggested in another comment). While such a scenario is theoretically possible, we think it would be very remote and could involve the closure of the MLI. The comment also suggested that a write-back could be based on an MLI achieving a particular ICR, but we have not adopted this because we did not consider it to be necessary to the design of the criteria.

A commenter suggested that a write-down or conversion feature would not be needed if the instrument documentation (or the MLI's policies) stated clearly that callable capital could not be used to pay the hybrid. We considered that this could, in theory, create the same economic effect. But, we decided not to adopt it because it would, in practical terms, be very difficult to determine whether callable capital funds were being used to pay hybrids. The funds, once received, will be fungible with other resources on the balance sheet and will facilitate business activity, so they could still be considered as providing the funds for any future hybrid coupons or redemptions.

One comment questioned whether an MLI could redeem a hybrid to create the economic equivalent of a temporary write-down. A temporary write-down would involve the principal amount being written down and subsequently being written back up to its original amount. We will only give equity content if there is a full and permanent write-down. The instrument cannot be redeemed after it has been written down fully because there will no longer be a liability owed to the investors. If an MLI redeems a hybrid when a mandatory write-down event is imminent, this would lead to us reviewing issuer intent and equity content for future hybrids. The criteria also state that an MLI's hybrids must be replaced with a new hybrid instrument or common equity prior to being redeemed for that MLI's hybrids to continue to be eligible for equity content.

Another comment suggested that MLI hybrid coupon suspensions should not be irrevocable, and any write-downs should be temporary, because a nonaccrual event by a borrowing member country would be temporary. We agree, which is why our criteria state that the permanent write-down feature only needs to activate if the MLI is drawing down callable capital, which we expect would only occur due to an extreme stress. While coupon nonpayments could occur in a less extreme stress (and we agree with the comment that they could cover losses on sovereign loans in less extreme scenarios), we anticipate that the types of losses that would lead to a mandatory coupon nonpayment would be significant. Noncumulative coupons also create more consistency with bank hybrids, which we see as important given that MLI balance sheet risks are typically most like those of banks.

Using an equity-to-development assets ratio as the mandatory coupon nonpayment trigger

We received a comment suggesting that an equity-to-development assets ratio be used as the coupon nonpayment trigger instead of our proposed equity-to-assets ratio. The comment proposed that "development assets" (defined as gross loans, equity investments, and guarantees) represent the risk-sensitive part of the balance sheet while the rest of an MLI's balance sheet is mostly cash and risk-free or low-risk treasury assets held predominantly for liquidity purposes. The commenter expressed concern that an increase in treasury assets, which would typically occur if an MLI was looking to increase its liquidity buffer and resilience to stress, could lead to a decline in the equity-to-assets ratio, which could penalize MLIs with lower risk appetites or those transitioning their funding plans.

We agree with the commenter that an equity-to-assets ratio is not a risk-adjusted measure of capitalization, and that bank hybrids typically use regulatory risk-weighted assets as the denominator in the capital-based triggers for their hybrids. We've decided to use an equity-to-assets ratio because development asset-based ratios also have limitations. For example, a ratio based on development assets doesn't address all the potential sources of balance sheet risks.

We agree that development assets are typically riskier than the treasury portfolio but not all treasury assets are risk-free or even low risk. Treasury assets will typically be sovereign-related bonds, but even these can have varying risk characteristics, and some MLIs have riskier treasury assets than others. Using an equity-to-assets ratio means that the trigger ratio will not exclude any assets that could cause future capital pressures. Using development assets as the denominator could lead to the hybrid coupon nonpayment trigger remaining high, even if there is a significant impairment of an MLI's balance sheet arising from treasury assets.

We expect to address the differences in MLIs' risk profiles through the equity-to-assets ratio. The level at which we would consider this ratio a going-concern trigger for a specific entity could differ from the going-concern ratio level for another entity. This would mean that an entity with lower-risk assets--for example, because it maintains higher liquidity buffers--could have a lower trigger ratio than an MLI with a riskier balance sheet. (A future shift in the riskiness of the asset base could lead to a lower SACP and lower hybrid issue credit rating through the impact on the MLI's RAC ratio and risk position assessment.)

While an equity-to-assets ratio will be lower than an equity-to-development assets ratio for the same entity, it's a more transparent ratio to market participants than one based on development assets. Also, we expect that any future write-off of development or treasury assets would have a similar impact on the trigger ratio.

The comment also proposed that using development assets would enhance consistency with bank hybrids that use regulatory risk-weighted assets as the denominator when determining maximum distributable amount constraints on coupon payments. Regulatory risk-weighted assets are not necessarily consistent measures of risk, however. Regulators can adjust banks' regulatory capital requirements to reflect their view of changes in underlying risk, but this is not the case for MLIs.

Another comment asked if triggers other than an equity-to-assets ratio could be used, such as another type of financial trigger. We have decided to limit the triggers to an equity-to-asset ratio. Other financial metrics could be helpful to indicate other type of financial stresses at the MLI but we have decided to keep the trigger capital-based because we incorporate the hybrids in our view of capital for the entity.

Setting the level of the mandatory equity-to-assets ratio trigger

One comment asked how we would set the level of this trigger. We don't set this in the criteria other than to state that it should occur at a level that corresponds to the entity still operating as a going-concern. An entity structures the terms and conditions of any hybrid that it plans to issue, including the ratio trigger level. We review the terms and conditions and assess whether that ratio is commensurate with going-concern status for that entity. We do not propose ratio trigger levels to an entity.

First call dates

One comment asked whether we could state in the criteria that an MLI hybrid is eligible for intermediate equity content if the period to the first call date is five years. We confirm that such an instrument is eligible for intermediate equity content, depending on whether its other features and issuer intent are also consistent with the features for intermediate.

We have not added a statement on this to the "Additional Considerations For MLIs And Multilateral Insurance Institutions" section, however. The sector-specific considerations are in addition to the cross-sector principles in the section "Equity Content Categories." We state in paragraph 27, which applies to all sectors, that an intermediate equity content hybrid must not be callable within five years of the issue date (unless the call option is based on an external event), and we don't override that by any specific considerations for MLI hybrids.

Replacement language

A commenter asked whether we could clarify that replacement language (stipulating how and when the hybrid may only be replaced to qualify for equity content) would not need to be inserted in the terms and conditions of the instrument itself but could be included in another part of the prospectus, in line with the common market practice for corporate hybrids. We confirm that the replacement language can be in any part of the hybrid documentation, which we define in the glossary to the criteria as "includes, but is not limited to, the hybrid offering circular, prospectus, and the information memorandum or agreement that contains the legal terms and conditions of the hybrid." We also state in the glossary definition that we review published statements that do not constitute part of the legal terms and conditions, but that influence issuer behavior (such as language relevant to replacement intent).

The comment also asked that the criteria clarify that an MLI hybrid would not need to be replaced if the issuer's creditworthiness had improved since the date that the hybrid was issued (as did one other comment), or in cases of deleveraging and balance sheet reduction. Although these conditions are referenced elsewhere in the hybrid capital criteria, we do not propose that they should apply for MLI hybrids.

We have aligned the replacement language criteria for MLI hybrids with that for bank Tier 2 hybrids, which are the only bank hybrids that are assigned equity content due to going-concern characteristics that do not benefit from regulatory oversight. For consistency with our approach to bank hybrids, we have maintained the language from the RFC, which states: "The hybrid documentation stipulates that it may only be replaced by issuing new common equity instruments (such as by a general capital increase) or by an equivalent or stronger instrument (with high or intermediate equity content) and that such a replacement would take place before the redemption of the instrument."

Replacement with new common equity

A comment proposed that new common equity should not necessarily need to be voting shares, given the potential dilution effect on existing shareholders and other challenges with giving new shareholders voting powers. We don't stipulate in the criteria that the new common equity needs to have voting rights. Although, we expect that any new shares should have similar loss-absorption capacity to other shares and have the same dividend rights as existing shares.

If an MLI uses treasury stock or generates capital reserves via profit generation, we do not consider it to have issued new common equity.

Dividend stoppers and the treatment of payments to concessional financing entities

One comment asked us to clarify that dividend stoppers (or other forms of restrictions on the distributions, such as payments to concessional financing entities, as MLIs rarely pay dividends) are acceptable for MLI hybrids. We confirm that common dividend stoppers generally have a neutral effect on our assessment of equity content for MLIs, as shown in table 4 of the criteria, which applies to all sectors in scope.

However, we do not consider MLI payments to a concessional financing entity to be a capital distribution because we see these payments as part of the MLI fulfilling its policy mandate. This is because an MLI provides concessional financing to facilitate its development objectives. We expect dividend stoppers to refer only to liabilities that are junior to the hybrid and do not consider concessional funds to be junior liabilities of an MLI.

We do not expect an MLI hybrid to have a term or condition that stops it from making payments into a concessional fund or to a concessional financing entity if the MLI stops paying the coupon on a hybrid. If an MLI stops paying on a hybrid to make a payment into a concessional fund, then we would consider this a default on the hybrid issue. (This would not affect the ICR on the MLI.) We would view this as the hybrid absorbing losses, or enabling the MLI to carry out activities that might not have been possible without the existence of the hybrid. In this way, the hybrid would act similarly to capital--consistent with the principles behind assigning equity content.

Redemptions and conversions

A commenter raised questions about redemptions and conversions.

The first was about how a hybrid could be redeemed in a time of stress and who would carry out any redemption valuation. The criteria state that only perpetual MLI hybrids will be assigned equity content. As such, there is no set maturity date. The MLI could choose to redeem the hybrid at an optional call date (set out in the hybrid documentation) if the replacement conditions are met. Hybrid documentation typically states the formula used to determine the value at which an instrument would be redeemed at an optional call date. An MLI is unlikely to redeem a hybrid at a call date if it is in stress because the hybrid would have to be replaced before redemption by another hybrid or by new common equity, which will be more difficult in a stress scenario.

An MLI could also redeem a hybrid by instigating an exchange offer or tender offer. We do not set the pricing or conditions of such an offer, which would be determined by the MLI.

The second question referred to who would value the MLI shares in the event of a conversion, given that MLI shares are not quoted on an exchange. We have added text to the criteria to clarify that, if the hybrid is to convert into common equity, we expect that the principal amount of the hybrid (e.g., $100 million) is replaced by common equity of the same amount (i.e., $100 million). This doesn't change our analytical approach because this is consistent with our approach to hybrid capital for other sectors. We also note that MLI management teams cannot carry out share buybacks to offset new equity in the same way as commercial entities.

Implications of hybrids given the status and role of the MLI sector

One commenter disagreed with the proposals and recommended that no hybrids in this sector be given equity content due to the special status of MLIs. Their concerns included that these entities are not subject to standard corporate or bankruptcy law and are not regulated.

We agree that MLIs have a different legal status to other entities because of how they are created, and because they are not subject to commercial law and there is no bankruptcy court to adjudicate claims among creditors or oversee a liquidation. We also agree that there is no prudential regulator to enforce coupon nonpayment, a principal write-down, or a conversion of a hybrid into common equity. For these reasons, the criteria lay out the types of contractual features that we expect to see within an MLI hybrid documentation for it to be eligible for equity content. We consider that hybrids issued with these features have equity-like characteristics and therefore can be included in our measures of capital, subject to limits.

Under the criteria, we consider coupon nonpayment, conversions, or write-downs that occur based on the contractual terms of the hybrid documentation. Clauses in documentation that describe a mandatory action (such as, if X occurs then Y happens within a set time period) can create an expectation about what will happen in given circumstances. We agree that legal proceedings can be complex for MLIs, as they are for some government entities, but we can assess their financial obligations based on the contractual terms and the MLI's intent to comply with these terms.

If an MLI were not to comply with a mandatory contractual feature in a financial obligation's documentation, this could change our view of issuer intent to have the hybrid act like capital in a stress scenario (potentially disqualifying other hybrids issued by the MLI from being assigned equity content) or weaken our view of management and strategy. We also take into account the unpredictability of how hybrids will be used in a stress by limiting the amount of hybrids we include in our capital measures. (This approach recognizes that hybrids are not as strong a form of capital as common equity.)

The commenter also raised concerns that hybrid investors that are also shareholders could try to delay or stop a write-down and might complicate any future restructuring discussions. We agree that restructurings could be complex for MLIs given the different incentives of the stakeholders, and the dynamics can differ depending on the specific case. We consider that hybrids can still play an equity-like role for an MLI, however. In the case of MLI hybrids, mandatory triggers would place a specified loss onto hybrid investors even in the absence of a restructuring process or negotiation. The fact that coupon payments are always discretionary, as well as the mandatory full and permanent write-down of principal (or equity conversion) in stress scenarios, may also lead to hybrid investors having different influence than senior investors during any such negotiations. If a restructuring were to take place in a stress scenario and hybrids did not incur losses, this could lead us to reassess issuer intent and remove equity content from existing and future hybrids of the MLI.

We also agree that shareholders are reluctant to see MLIs call on callable capital. But, if an MLI has issued a hybrid, the MLI will already have the financial resources on its balance sheet (which is not the case for callable capital) with no scheduled repayment date to the investors.

Implications of hybrids for the quality of capital in the MLI sector and for future support

The commenter saw hybrids as leading to weaker capital standards for MLIs and potentially signaling that government shareholders will be less likely to provide future equity support. They also discussed how this could affect the ability of MLIs to play their role within the global financial system.

We agree that hybrids are not as good a form of capital as common equity and therefore limit the amount that we will include in our capital measures. Hybrids can act like capital in various scenarios, however, and we address this by the loss-absorption features outlined in the criteria for MLI hybrids, including mandatory and discretionary noncumulative coupons, as well as either a full permanent write-down feature or a conversion into common equity.

We also agree with the commenter that MLIs typically have relatively high capital levels and that some shareholder governments may become more reluctant to provide general capital increases to MLIs or look to delay them. This is a broader issue for the MLI sector--and not solely due to, or linked with, the potential use of hybrids. The development of MLI hybrids can be seen partly as a replacement for general equity injections but also as a result of emerging capital management strategies and relationships within the sector.

Capital optimization, with a focus on using the balance sheet (and off-balance-sheet exposures where appropriate) more efficiently, is already a topic among MLI stakeholders and policymakers. We factor this into our MLI criteria via our policy importance assessment, which we can adjust to signal weaker expectations of support. Under the MLI criteria, we can also limit the amount of callable capital that we give credit to for a specific MLI. Lower capital ratios also feed into a lower rating under the MLI criteria. Our assessment of MLI capital also takes into account the preferred creditor status of MLI activities and the impact of concentrations in their loan portfolios and loss experience. These features of the MLI criteria are not affected by the new hybrid capital criteria. For more of our views on capital management dynamics and constraints for the MLI sector, see "Can Multilateral Lenders' Capital Bases Hold Up Against COVID-19?", June 9, 2020, and "Introduction To Supranationals Special Edition 2021," Oct. 27, 2021.

Coupon loss absorption

The comment also cited the limited financial effect of stopping coupon payments, particularly when interest rates are low. We agree that stopping coupon payments can have a limited financial impact, although it can still be helpful to an issuer depending on the situation. Our criteria require that MLI hybrids also have a permanent full principal write-down or equity conversion feature so that the hybrid will have greater capacity to absorb losses than through coupon nonpayment only. Any discounted buyback or tender offer on the hybrid could also offset losses by reducing the liability amount.

Mandatory loss-absorbing triggers

The commenter also expressed concern about whether a mandatory trigger will be effective if MLIs don't have regulators to assess their financial statement or how they classify their assets. We agree that each MLI determines its financial metrics differently, but these numbers are audited at least annually. We can also assess whether we consider any mandatory trigger to be equivalent to a going-concern status based on our opinion of the specific policies and risk profile of that MLI. If we see an MLI start to report its financials more favorably than we consider warranted, this could affect the rating on the MLI by weakening our view of either risk position or management.

We address concerns about information quality or transparency according to our rating policies, which apply to all sectors. Concerns can result in an entity not being rated, or in a lower rating to reflect heightened uncertainty.

We expect that MLIs would disclose publicly and regularly the level of the financial metrics that are cited in any mandatory trigger clauses.

Identity of investors

The same commenter made several comments regarding potential hybrid investors.

They recommended that central banks should not be allowed to invest in MLI hybrids. We haven't adopted this because we don't regulate or set central banks' investment policies. If the investment portfolio of a central bank to which we have assigned a rating were to become materially riskier, this can affect our rating on the central bank, however.

They also discussed how an MLI could become more akin to a commercial bank if nongovernments become shareholders due to hybrid holdings converting into equity. We agree that an MLI could transition to being considered a commercial bank if its ownership structure changes--in which case we would assess the entity using our FI criteria. We will only assign equity content to a hybrid that converts into common equity if the investor is clearly able to hold common equity in the MLI.

This comment also recommended that high equity content should only be assigned if the government that invests in the hybrid is also a member government of the MLI, (i.e., a shareholder). We agree and have clarified this in the criteria. This doesn't change our analytical approach because we expect member governments to be more likely to provide long-term support than other entities. We also expect hybrids invested in by member governments to be more likely to be convertible into common equity for that MLI.

Previous hybrids in the MLI sector

We received a comment referring to a hybrid that was previously issued by an MLI. We have reviewed this case and confirm that the instrument in question was a nondeferrable subordinated bond. As such, the instrument could not absorb losses prior to the liquidation of the entity and would not meet our definition of a hybrid.

Significant Analytical Changes To The Final Criteria That Did Not Arise From Market Feedback

We finalized and published the criteria without making any significant analytical changes that are unrelated to the external written comments or other market feedback we received.

However, we incorporated editorial revisions to update paragraph and table numbers, remove redundant text, and add references to the associated guidance article. These edits did not change the analytical approach. We also placed the equity content and rating the issue text for MLI hybrids alongside the equity content and rating the issue text for the other sectors instead of in a separate section. This was to aid readability and does not alter the analytical approach.

In addition, we added text to clarify that--when assessing whether to assign equity content to a hybrid--we consider whether the MLI has the authority to issue a hybrid according to its internal governance processes and would expect to receive comfort that this is the case. We also added text to make it clear that hybrid instruments do not, in our view, transfer or extend the preferred creditor status of the MLI to the hybrid investors. Neither of these clarifications alters the analytical approach.

We also clarified in table 1 that high equity content hybrids issued by MLIs are only included in TAC up to an amount equivalent to 50% of ACE, even if invested in by governments. This also doesn't change the analytical approach but makes it clearer than in the RFC text.

Related Criteria

• Hybrid Capital: Methodology And Assumptions, March 2, 2022
• Multilateral Lending Institutions And Other Supranational Institutions Ratings Methodology, Jan. 31, 2022