After showing a marked preference for conventional and Islamic hybrid capital instruments over the past decade, we believe volatile conditions could prompt a change of approach from GCC banks.

Liquidity is becoming scarcer, and more expensive, even in the Gulf. Current market conditions mean banks that replace an existing hybrid capital instrument with a new one could incur a significant increase in their cost of capital. Therefore, S&P Global Ratings anticipates that over the next 12-24 months, more banks in Gulf Cooperation Council (GCC) countries will refrain from calling their hybrid instruments at the first optional call date.

At Sept. 30, 2022, hybrids contributed an average of 13.5% to total adjusted capital (TAC) at the region's rated banks, up from an average of 2.3% at year-end 2011. TAC is our main measure of a bank's absolute capital level. That said, these averages conceal significant variations. Some banks have issued no hybrid instruments at all; others have almost a quarter of their TAC in hybrids. In addition, while most GCC banks issued only additional Tier 1 (AT1) instruments, which absorb losses or conserve cash while the bank is a going concern and are incorporated into TAC, some also issued Tier 2 instruments. These typically absorb losses only at the point of nonviability and are not included in TAC.

A noncall decision doesn't constitute an event of default and can be credit supportive, in our view. Moreover, the impact on banks' reputations from such decisions has been limited and short-lived in developed markets and the GCC. Notably, a bank decision to exercise an optional call depends, in part, on regulatory approval. So far, we are not aware of any regulatory objections following a GCC bank's announcement that it intends to call its hybrid, but regulators reserve the right to challenge such decisions.

When rating hybrid instruments, we typically use the bank's stand-alone credit profile as a starting point, even though we consider four of the six GCC countries to be highly supportive of their banking systems. We do not expect government support to accrue to hybrid instruments because they are intended to absorb losses and help recapitalize banks with solvency concerns. In most cases, their terms and conditions specify that the injection of public sector capital would trigger the instrument to absorb losses.

GCC Banks Have Boosted Their Capital By Issuing Greater Volumes Of Hybrids

Issuance of AT1 capital instruments, in particular, has accelerated over the past decade (see table 1). GCC banks issued both conventional AT1 instruments and Islamic instruments (typically using a mudaraba structure). At Sept 30, 2022, AT1 instruments comprised an average of 13.5% of TAC at rated GCC banks, up from 2.3% at year-end 2011. However, there is considerable variation from bank to bank (see chart 1). Banks in some countries, such as Saudi Arabia, also issue Tier 2 instruments, which absorb losses only when the bank is a gone concern. We typically consider these to have no equity content and they are not eligible for inclusion in TAC.

Table 1

Chart 1

Both Islamic and conventional hybrid AT1 instruments allow issuers to suspend payments--periodic distributions for the Islamic instruments and coupons for the conventional instruments--without triggering a default, while the bank is still a going concern. Both can also be written down at the institution's point of nonviability, which is frequently defined as the point at which a bank's capital level drops below the minimum required to maintain its license. To this end, regulatory authorities have a range of powers to determine whether a specific institution is no longer a going concern. It is also defined, in the legal documents of many of these instruments, as the point at which a bank is likely to receive extraordinary government support.

Investors in GCC hybrids vary by country

Banks in some GCC countries, such as the United Arab Emirates (UAE) and Bahrain issued a large portion of their AT1 instruments on the international capital market, in hard currencies. By contrast, in Saudi Arabia and Qatar, we saw more of a focus on the local market, with issuance denominated in local currencies. Local investors may include cash-rich governments and their related entities, which invested to provide support for banks while receiving a defined return.

Hybrid Financing Is No Longer Inexpensive

From 2018 to early 2022, it was relatively easy to issue a replacement hybrid at a cost in line with, or cheaper than, that of the original. As a result, issuers in the GCC, like those elsewhere, typically called hybrids on the first optional call date.

However, high inflation prompted major central banks, including the U.S. Federal Reserve, to significantly raise interest rates over the past 12 months. GCC central banks had to follow suit to preserve their currency pegs with the U.S. dollar (the Kuwaiti dinar is the only regional currency not fully pegged to the dollar). As a result, local (and global) liquidity has become much more expensive, and scarcer.

Moreover, we have seen a significant increase in investors' risk aversion, and credit spreads. For some major segments of the capital markets, including speculative-grade issuers, activity in 2022 was well below that in 2021.

How will this affect issuer and investor decisions?

With low-cost hybrid instruments no longer available, we expect more noncall decisions in the GCC in the near future. Indeed, some noncall events have already occurred, with Qatari and Omani issuers choosing not to redeem hybrid instruments on the first call date over the past three years. So far, Saudi banks have been able to refinance all their hybrid instruments at a comparable cost and redeemed them on the first optional call. These were all denominated in Saudi riyals.

More noncall decisions could result in investors pricing in this risk more explicitly, which would further increase refinancing costs for issuers.

No Government Support For Hybrid Instruments

Of the six GCC countries, four are classified as highly supportive toward their banking systems. However, hybrids are intended to absorb losses and therefore no government support would accrue to holders of AT1 or Tier 2 instruments, in our view. The terms and conditions typically specify that an injection of public sector capital is considered a point of nonviability or a trigger point for the instrument to absorb losses. Therefore, we use the bank's stand-alone credit profile as the starting point when rating hybrid instruments.

AT1 instruments buttress banks' capitalization and protect senior creditors

We classify most AT1 instruments, issued by rated banks, as having intermediate equity content because we consider that they would be able to absorb losses or conserve cash when needed while the bank is still a going concern. The instrument must also meet the other requirements for being assigned intermediate equity content, such as being eligible for inclusion in regulatory capital (see "General Criteria: Hybrid Capital: Methodology And Assumptions," published March 2, 2022, on RatingsDirect). Therefore, they are included in TAC and have helped banks to maintain strong capitalization in recent years. At year-end 2021, GCC rated banks had an average risk-adjusted capital ratio of 11.3% (see chart 2). In our view, strong earnings and relatively conservative dividend payouts suggest that this ratio is likely to have remained stable through 2022 and into 2023.

Chart 2

AT1 instruments protect senior creditors, mainly by facilitating ongoing cash conservation. Issuers may choose to suspend the payment of coupons or periodic distributions, and at the point of nonviability they can also write down the principal of these instruments. In addition, if an issuer decides not to call an instrument, it will not need to refinance it. Even if the rate resets on the first optional call date, it may still be less expensive than refinancing in the current market.

A noncall decision may also provide more protection to senior creditors than the alternatives, which include:

• Issuing a new hybrid at a higher coupon, especially if the creditworthiness of the issuer has deteriorated since the existing hybrid was issued;
• Redeeming the hybrid and replacing it with senior debt, which would lower the bank's capitalization and require regulatory approval; or
• Redeeming the hybrid without replacing it, which would also lower the bank's capitalization and require regulatory approval but, in addition, could weigh on the institution's funding and liquidity profile.

Regulators Hold The Key

GCC regulators often reserve the right to approve any decision to call a hybrid. Typically, they require banks to replace these instruments with others that have equal or stronger capital content. To date, no regulator has publicly challenged a GCC bank's announcement that it intends to call its hybrid. That said, a regulator could force a bank to change course if it considers the call decision to have implications for the bank or banking system's creditworthiness.

Hybrid instruments enable banks to optimize returns to their shareholders and increase their return on equity, while still providing protection to depositors and senior creditors. In the GCC, they are also issued as part of a bank's regulatory capital. Therefore, regulatory action can accelerate a bank's decision to call its instrument, for example, if an instrument ceased to be part of regulatory capital. Typically, issuers have the option to redeem if there is a regulatory capital disqualification event.

GCC Banks' Capital Levels Are Unlikely To Deteriorate

Hybrid capital instruments are more complex structures than senior bonds. The risks for investors and issuers are not the same and are designed to shift according to prevailing credit conditions. We anticipate that, as investors continue to price in the risk of a noncall decision, GCC banks will reduce their issuance volumes and that some will refrain from calling existing hybrid instruments. Given that many of the region's banks have issued no hybrids at all, the market can likely accommodate a shift toward other forms of capital. That said, we may see some sporadic activity.