The bank hybrids capital market is rebounding. This is despite it being more expensive and difficult for banks to issue hybrids for several months earlier this year after the Swiss franc 16 billion write-down, in March, of Credit Suisse AG additional tier 1 (AT1) hybrid capital instruments shook bank hybrid investors.
Swiss authorities enforced the 100% write-down features of the Credit Suisse instruments as part of the government-facilitated takeover of Credit Suisse by UBS AG without also wiping out common equity shareholders. This event highlights the tail risks associated with AT1 instruments noting that investors are now returning to the asset class on the back of relatively high coupons and more comfort about the risks facing most bank issuers.
Rising rates have added another layer of conundrum for some issuers and investors. As banks approach the optional call dates for these instruments, they may be tempted to not redeem the hybrids and hence avoid refinancing at higher costs. In many cases we expect the optional call will occur, however, in keeping with typical investor expectations when market conditions are healthy.
|Asia-Pacific FI Virtual Conference 2023: Emerging Risks, Emerging Opportunities|
|Panel: Innovative Capital Instruments--Strong Issuance Prospects As Asia-Pacific Continues To Evolve, Mature|
|Gavin Gunning, Senior Director, Sector Lead, Global and Asia-Pacific, Financial Institutions Ratings, S&P Global Ratings||Sharad Jain, Director, Financial Institutions and Sovereign & International Public Finance Ratings, Pacific, S&P Global Ratings|
|Ryoji Yoshizawa, Senior Director, Sector Lead, Financial Services and International Public Finance Ratings, Japan, S&P Global Ratings|
|Phyllis Liu, Director, Financial Institutions Ratings, Greater China Region, S&P Global Ratings|
|Daehyun Kim, Director, Financial Institutions Ratings, Korea, S&P Global Ratings|
|Ivan Tan, Director, Financial Institutions Ratings, South and Southeast Asia, S&P Global Ratings|
Investors' unease about bank hybrids in the immediate wake of Credit Suisse came amid a wave of issuance of anticipated new total loss-absorbing capacity (TLAC) instruments from China. Earlier this year, we forecast that the country's major banks would raise about US$500 billion-equivalent from the sale of TLAC-eligible instruments before January 2025. This would be done to meet new TLAC requirements, we assumed.
It adds up to higher stakes for investors and issuers, involving heightened risks and opportunities for all. To provide a forum for the many investor queries on this matter, we ran a session on this topic during our recent two-day financial institutions conference. We address the investors' frequently asked queries below.
Frequently Asked Questions
Was it surprising that the Credit Suisse hybrids were fully written down, even as the equity preserved some value? Could the same treatment occur for AT1 instruments issued by Asia-Pacific banks?
Sharad Jain: It was not surprising given that the Credit Suisse AT1s had permanent complete write-down features that could be activated without the regulator putting the bank into a formal resolution process. AT1 instruments are designed in part for the express purpose of absorbing losses in a stress scenario. The typical AT1 security carries significantly higher credit risks compared with the senior debt issued by the same bank. That's why we typically rate a bank's AT1 instruments four or more notches below our view of its stand-alone credit profile.
The Credit Suisse write-down was an event specific to that institution, the laws and regulations that govern it, its own operating circumstances, and the specific features of these instruments. For example, all the Credit Suisse AT1s had full write-down features, not conversion features. Asia-Pacific banks in a similar situation would chart their own course.
Take conversion versus write-down features--these vary by jurisdiction depending on the regulator and investor preferences. For example, the regulation in Australia, Japan, and India is very similar on this count. In each of these jurisdictions, the regulation allows AT1 instruments to have either conversion or write-off options in a loss-absorption or a nonviability event. However, market practices differ.
In Australia, the terms of listed banks' AT1 instruments typically state that these instruments would convert into common equity in a loss-absorption or during a nonviability event. In contrast, the terms of AT1 issued by the Indian banks and Japanese banks typically stipulate a write-off (see "Asia-Pacific AT1 Hybrids Investors: Understanding The Credit Suisse Fallout," published March 24, 2023, on RatingsDirect).
Some believed the Credit Suisse write-down would seriously disrupt the market for Asia-Pacific bank hybrid issuance. But the market bounced back quickly. Why?
Sharad Jain: The AT1 market is not immune to disruptions. Spreads widen during volatile times, and there are several past examples where the primary market for AT1s has closed for some months for certain issuers--for example in the aftermath of the global financial crisis. But markets tend to normalize and spreads revert to close to pre-disruption levels, or at least to narrower than in the immediate aftermath of the stress. We are now seeing a similar pattern in Asia-Pacific where investors are investing in bank-issued hybrids because of their view of the risk-rewards.
For example, in Australia:
- Australia and New Zealand Banking Group Ltd. (ANZ) priced its Capital Notes 8 in February at 275 basis points (bps) above the 90-day bank bill swap rate. This was before Credit Suisse's write-down.
- Commonwealth Bank of Australia priced its CommBank PERLS XVI Capital Notes in May at a spread of 300bps, or 25bps above the spread paid by ANZ. This was a few weeks after the Credit Suisse write-down in March.
- Then, in late August, National Australia Bank Ltd. (NAB) priced its NAB Capital Notes 7 at a spread of 280bps, which is only 5bps above what ANZ paid before Credit Suisse's write-down. We see in the three events a fairly rapid progression to reaction, and then to normalization, for hybrids issued by three banks of a similar credit standing that are based in the same country.
Why did a Korean insurer reverse its noncall decision on an outstanding hybrid late last year, and how has this affected our equity content assessment of the Korean banks' and insurers' hybrids?
Daehyun Kim Let me recap what happened. In November 2022, Heungkuk Life Insurance Co. Ltd. announced its intention to not call a US$500 million hybrid at an optional call date. This inflicted a significant hit on the price of hybrids in the secondary market, not only for the Heungkuk Life security but for other hybrids issued by Korean insurers. This affected the Heungkuk Life's business operations, with media reports citing an increase in policy cancellations. A couple of days later the company changed its mind and announced that it would exercise the call.
We understand that the regulators were supportive of the company reversing its decision and exercising its call options. This was despite that, at the time of the redemption, we estimate the life insurer's capital ratios fell below the regulatory requirement which the company should meet to exercise a call option (i.e., regulatory solvency ratio of 150%).
This event has raised questions about whether call options on Korean hybrids will always be exercised even if the issuer is under stress. If that were the case, the effective maturity on the hybrid would be the call date, which means the hybrid is not sufficiently long-dated to be treated as equity.
We decided to maintain equity content on outstanding hybrids from Korean banks and insurers because it's premature to assume, based on this single event, that these companies do not have sufficient flexibility with their call options. We see the Heungkuk case as idiosyncratic and not indicative of a shift in the regulators' capital-management approach.
We expect that Korean regulators will continue to encourage and oversee prudent capital management by regulated entities (See "Equity Content Assessment Of Korean Bank And Insurance Hybrids Unchanged Following Recent Call Event," Dec. 7, 2022). Notably, Heungkuk Life raised its capital ratio back above the regulatory requirement in the following month after the noncall announcement, on the back of capital injections by affiliates. We expect the banks and insurers to retain ability not to call if that would put pressures on their regulatory capitalization (and we note that one of the major Korean banks has not exercised optional call in previous market downturn in 2009).
How Do We Define The Terms ALAC, Hybrid?
This report frequently uses the terms hybrid and ALAC (additional loss-absorbing capacity). As the definitions of these concepts vary, we include our inhouse, criteria derived definitions below:
ALAC: A source of incremental credit strength for a financial institution's (FI) senior unsecured obligations that, in some jurisdictions, can absorb losses of an FI at or near nonviability--for example, in the event of a resolution--addressing unrecognized losses and recapitalizing an FI as necessary in a way that reduces the risk of it defaulting, according to our definitions, on its senior unsecured obligations. An FI's ALAC is the sum of:
- Its hybrid capital instruments not included in total adjusted capital that have the capacity to generate common equity, through conversion into common equity or a principal write-down, at the initiative of the authorities when the FI is failing; and
- In some jurisdictions, senior and subordinated obligations of its non-operating holding company.
Hybrid capital: This generally refers to an instrument that has characteristics of both debt and equity, and therefore excludes common equity. We consider an instrument to be a hybrid capital instrument if, and only if, without causing a legal default or liquidation of the issuer, it can absorb losses or conserve cash. Examples of such loss absorption or cash conservation include:
- Deferral of the coupon;
- Write-down of principal; or
- Conversion into common equity or another hybrid capital instrument.
For further discussion, see "Hybrid Capital: Methodology And Assumptions," March 2, 2022," and "Financial Institutions Rating Methodology," Dec. 9, 2021.
Australian regulators have emphasized that investors should not presume that calls are automatic. Should we be surprised by this reminder?
Sharad Jain: No in the context that this is consistent with the regulatory role of these instruments. You are talking about an announcement by the Australian Prudential Regulation Authority (APRA) in November 2022. We viewed the regulatory stance as consistent with our assessment that these hybrids have some equity-like features. APRA's announcement underscored the loss-absorption and cash conservation characteristics of hybrid capital instruments issued by banks.
We have generally believed that AT1 instruments issued by the Australian banks will remain outstanding for a sufficiently long period and therefore be available to absorb losses or conserve cash. Consequently, we have typically assessed these AT1 instruments to be of intermediate equity content.
The optional nature of a call is important. Under benign operating conditions, the call allows the issuer to refinance the hybrids with equal or better-quality capital instruments. But the issuers may also choose to not exercise calls to maintain the level and quality of their capital, particularly during tougher operating conditions.
How is China progressing with the implementation of its TLAC program, and can the shortfall in issuance be met by 2025?
Phyllis Liu: Four mega banks (the "big four") in China are designated as global systemically important banks (G-SIBs). They are therefore required to hold TLAC capital that is equal to 16% of risk-weighted assets by the beginning of 2025. Our estimate earlier this year is that the banks still have Chinese renminbi 3.7 trillion capital gap to fulfill by the start of 2025.
We expect the big four banks to issue a combination of traditional regulatory capital instruments alongside senior nonpreferred instruments. In April 2022, a directive outlined rules for issuance of TLAC that widened the channels for such issuance.
In the first half of 2023, regulators approved the capital replenishment plans of some mega banks. However, no senior nonpreferred instruments have been issued so far.
Regulators might help banks to meet the capital target by encouraging them to speed up the pace of new capital issuance and reduce the proportion of high-risk-weighted assets.
What have been the recent TLAC developments in Australia and Japan?
Sharad Jain: The TLAC and resolution frameworks for banks in Australia differs significantly from that in Western Europe and North America in many ways.
Unlike those jurisdictions, statutory bail-in of senior unsecured obligations of a bank does not appear to be a feasible option in Australia.
In many other countries, the legislation requires that the government may bail out a failing bank only after substantial absorption of losses by junior creditors. No such legislative restriction currently is part of the framework in Australia.
The Australian authorities continue to hold a pragmatic view that government support for the systemically important banks remains a preferred option to maintain financial system and economic stability.
And, finally, Australian authorities have not introduced a new class of capital securities to boost banks' total loss absorbing capacity. Rather, all common equity Tier-1 (CET1), additional Tier-1 and Tier-2 capital is eligible for inclusion within the TLAC.
Under Australia's TLAC framework, the four major banks, which are designated domestic systemically important banks, are required to raise their TLAC to 18.25% of the regulatory risk weighted assets by January 2026. We consider that these banks are well on track to meet the regulatory requirement.
Ryoji Yoshizawa: TLAC issued by the Japanese banks have the same contractual terms and conditions as those issued by U.S. or U.K. banks.
However, we do not treat Japanese banks' TLAC as a hybrid instrument--our rating on such securities is at the same as our rating on the bank holding company. This treatment is different from AT1 of Japanese banks; these instruments are regarded as hybrids.
In other words, even though the TLAC issued by Japanese banks fully meet the contractual standards set by Basel, the TLAC instrument ratings are notched down from the supported group credit profile, which incorporates government support.
We base this on our view that the Japanese government maintains a highly supportive stance toward TLAC issued by private-sector banks in Japan. We also expect the government to provide support to the holding company of Japanese G-SIBs.
Article 102 and 126 of Deposit Insurance Act clearly states how the government support is to be provided. The government has a record in providing preemptive capital support to systemically important banks to avoid crises.
What are the main issuance trends for banks in South and Southeast Asia? What key developments should investors look for?
Ivan Tan: Tier-1 issuance across ASEAN has been lukewarm in 2023. ASEAN banks' dependence on AT1 is inherently low--the overwhelming bulk of their capital being CET1--so this does not materially affect their capital flexibility.
Highly rated banks continue to be able to access the AT1 market. A case in point, Oversea-Chinese Banking Corp. Ltd. (AA-/Stable/A-1+) issued a perpetual AT1 in August, with a yield of 4.5%. That level compared favorably to yields on risk-free 'AAA' government bonds of about 3.8%.
That said, this issuance was done to refinance an AT1 that was called. Around Singapore dollar (S$) 1 billion was called, but the bank only raised S$550 million in new AT1s. This suggested that the attractiveness of the ATI instrument category for the issuer has cooled.
Our ratings on Chinese G-SIBs' senior nonpreferred TLAC bonds assumes government support in a stress situation. We don't hold this view on TLAC bonds issued by G-SIBs in other regions. Why not?
Phyllis Liu: Our view takes into account the strong ties that the big four have with the central government and the extremely high likelihood of state support in a distress event, given the big four banks' key role in supporting the Chinese economy and advancing policy. The government is also their majority owner. For all these reasons, we see the Chinese government as being highly supportive of the banking sector.
We therefore expect the starting point for the ratings on the senior nonpreferred TLAC bonds would very likely be the issuer credit rating, which assumes that state pre-emptive measures would kick in before the instruments failed. We would apply a one-notch downward adjustment from that starting point to account for subordination.
By contrast, the starting point of rated TLAC-eligible senior debt instruments in the U.S. and Europe is the stand-alone credit profile, reflecting the uncertainty of government support should a bank fall into distress.
Somewhat similar to China, we assume intervention by the Japanese government would likely rule out the triggering of the nonviability contingency capital clause for AT1 instruments issued by systemically important banks. Why?
Ryoji Yoshizawa: Global standards typically require AT1s to have two loss-absorption mechanisms. The first is the contingency capital clause, also known as the point of nonviability trigger. The second is a mechanism for principal write-down should the bank's CET1 fall below a certain level.
We view as low the likelihood that the financial condition of a Japanese major banks would trigger a contingency capital clause. Government support, including a capital injection, would likely head off a bank's financial deterioration. Such a capital injection would not trigger the contingency clause.
We believe there is still a risk of a write-down of principal in the case that bank's CET1 suddenly fell below a threshold--e.g. below 5.125%.
There was a case in which a bank's regulatory capital ratio fell far short of regulators' expectations, from an estimated 6% to actual 2%. That was in 2003, before the introduction of Basel III regime, when the government injected capital into Resona Bank Ltd.
To view a video replay of this session, go to this link.
This report is part of a series that reference comments made at an event titled S&P Global Ratings Asia-Pacific Financial Institutions Virtual Conference 2023: Emerging Risks, Emerging Opportunities
Writer: Jasper Moiseiwitsch
- Asia-Pacific AT1 Hybrids Investors: Understanding The Credit Suisse Fallout, March 24, 2023
- China's Major Banks Still Have An RMB3.7 Trillion Shortfall On TLAC Requirement, Jan. 18, 2023
- Equity Content Assessment Of Korean Bank And Insurance Hybrids Unchanged Following Recent Call Event, Dec. 7, 2022
- Credit Implications Of Hybrid Noncall Decisions, Nov. 24, 2022
- Hybrid Capital: Methodology And Assumptions, March 2, 2022
- Financial Institutions Rating Methodology, Dec. 9, 2021
This report does not constitute a rating action.
S&P Global Ratings Australia Pty Ltd holds Australian financial services license number 337565 under the Corporations Act 2001. S&P Global Ratings' credit ratings and related research are not intended for and must not be distributed to any person in Australia other than a wholesale client (as defined in Chapter 7 of the Corporations Act).
|Primary Credit Analysts:||Gavin J Gunning, Melbourne + 61 3 9631 2092;|
|Sharad Jain, Melbourne + 61 3 9631 2077;|
|Daehyun Kim, CFA, Hong Kong + 852 2533 3508;|
|Phyllis Liu, CFA, FRM, Hong Kong +852 2532 8036;|
|Ivan Tan, Singapore + 65 6239 6335;|
|Ryoji Yoshizawa, Tokyo + 81 3 4550 8453;|
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