by
Justin McCarthy | Jun 06, 2013
1. Step-up clause
New Basel III rules (which have been adopted by APRA) explicitly prevent the use of step-up margins on any new regulatory capital instrument such as subordinated debt or Tier 1 hybrids. Step-up clauses were seen to be “incentives to call” by the Basel Committee and have been outlawed (see below for further detail).
“Old-style” step-up securities issued before the change in capital rules have been given grandfathering relief to still count towards the capital calculations (albeit on a reducing basis) however only until the first call date, after that date their contribution to capital immediately falls to zero. Further, APRA has previously stated “outstanding non-complying instruments [read step-up securities] will be required to be phased-out no later than their first available call date, where one exists”.
The existence of a step-up clause is an important differentiation in a subordinated debt (or Tier 1 hybrid) security. It is a typical feature of “old-style” securities and given the treatment under the revised Basel III and APRA capital rules, provides a strong incentive for the issuer to call at first opportunity. No such incentive exists for “new-style” subordinated debt and further, the lack of such a clause is a movement towards economic-based call decisions.
2. Expectation of call
Following on from the step-up discussion above, one of the key thrusts of the new Basel III (and APRA) capital rules is to remove any indication to the market that a capital security is intended to be called at first opportunity. Rather, regulators want issuers to make each call decision on the economic merits of cost versus benefit (i.e. is it cheaper to call and re-issue another similar security and if not the issuer should not exercise their call option).
By removing “incentives to redeem” (including step-up clauses) from the structure of newly issued capital securities, the issuers are being forced by regulators to use an economic rationale to the call decision. Further, investors will no longer be able to rely on reputational grounds for expectation of call at first opportunity. Issuers have been very careful in their marketing of new issues to ensure they do not give investors the expectation that “new-style” subordinated debt or Tier 1 hybrids will be called at first opportunity.
APRA have even suggested that if an issuer was to request its approval to call a capital security with the intention to replace it with a new issue with a similar structure but at a higher margin, they would decline the request.
It is anticipated that once the “old-style” securities, particularly step-up securities, no longer exist in the market that the long held expectation of call at first opportunity will change. Basel III and APRA are pushing for a market where both the issuers and investors expect callable securities to be called only when it is economic for the issuer to do so. We believe the market will make this transition over the next three to four years.
Based on the discussion above, the expectation of call at first opportunity is much stronger for “old-style” step-up securities than the “new-style” that will be assessed purely on economic grounds.
3. Non-viability clause
Any new subordinated debt (or Tier 1 hybrid) security issued after 1st January 2013 by an APRA regulated entity must include a “non-viability clause”. This is another of the sweeping changes under Basel III (and again adopted by APRA) and states that if the regulator at its sole discretion believes an issuer is at the point of “non-viability”, then they can require that any capital securities with the requisite terms in the documentation be written off (the default position) or converted to equity (if the issuer is listed and this is requested by the issuer at the time of structuring the deal). This is a material increase in risk for “new-style” subordinated debt in particular and worthy of further assessment.
Firstly, the point of “non-viability” is not defined. In layman’s terms it is when the regulator deems the issuer to be sailing too close to the wind but that may be on capital grounds or liquidity or even due to a high balance of non-performing loans. The key risk here is that unlike the recent “bail-in” or write-off clauses in Tier 1 hybrid securities that trigger a capital loss or haircut if a pre-determined trigger is hit (e.g. Core Equity Tier 1 ratio falls below 5.125%), the trigger here is at the regulator’s sole discretion. One probable trigger point would be a government equity injection or similar state support to an ailing bank, something that occurred with many big name banks in Europe in the GFC such as RBS, Lloyds and ING.
Secondly, it is only new issues post 1 January 2013 that have this clause (with a few exceptions). This means that in the event it is triggered, new issues such as the Suncorp ASX listed subordinated bond could be converted to equity where “old-style” subordinated debt and even Tier 1 hybrid issues that do not have such a clause could not be converted. This would effectively make the “old-style” securities senior in ranking. While this will only exist for the period that both “old-style” and “new-style” capital securities exist, it is an important and very relevant additional risk that in some ways is closer to Tier 1 hybrid risk than traditional subordinated debt risk. Further, the lower the credit quality of the issuer, the greater this risk becomes. It could be argued that the major banks could get away with this risk being seen as not particularly onerous but for the smaller regional banks it becomes a greater concern.
Lastly, the existence of these additional risks and in particular the difficulty in assessing or hedging again the subjective “point of non-viability” greatly reduces the attractiveness to the wholesale (or over the counter bond) market. In addition, many institutions cannot hold securities that may be converted into equity (although there does seem to be some innovative solutions being suggested in the Suncorp deal). As such, there is limited intuitional buying interest. A cynical view would be to suggest that the retail listed market is the preferred home for such “new-style” securities as retail investors are less aware of the differences in risk and rather simply concentrate on comparative returns to other banks products such as term deposits and listed subordinated debt and Tier 1 hybrid securities.