Sub debt becoming a riskier proposition

Published in the Australian Banking and Finance Magazine, August 2013 by Marion Williams

Bank subordinated debt carries much more uncertainty for investors than it previously did.

 In part this can be linked back to the new tier 2 capital requirements under Basel III around non-viability triggers whereby the instruments would convert into equity or be written off. 

The Australian Prudential Regulation Authority (APRA) would pull that trigger if it decides that a bank would otherwise become non-viable or require a public sector injection of capital.

 APRA wants to step in before a bank becomes insolvent so that the bank can continue operations rather than fail. 

The uncertainty for investors is that APRA won’t define “non-viability”. 

As Elizabeth Moran, director of education and fixed income research at FIIG Securities asked, “if wholesale funding markets closed down like they did during the global financial crisis and the bank could only fund itself with a government guarantee, would it be deemed non-viable?”.

When APRA consulted on its planned implementation of Basel III capital reforms last year, several submissions sought guidance on the factors that APRA would likely consider when triggering the non-viability provisions. 

APRA responded in September that “it isn’t possible to define in advance the circumstances or factors that would lead APRA to conclude that an authorized deposit-taking institution has become ‘non-viable’.”

Market participants view APRA’s stance as maintaining flexibility to ensure it has every tool available to deal with another crisis or an institution under severe financial stress. 

Against this backdrop of regulators’ evolving approach to better quality regulatory capital and a seeming shift to “burden-sharing” rather than bailouts, Moody’s Investors Service (Moody’s) has put the Basel II compliant subordinated debt of eight Australian banks under review.

Patrick Winsbury, senior vice president of Moody’s financial institutions group, said that the ratings agency is considering whether, in the event the new Basel III-compliant instruments were written down, would the older Basel II-compliant instruments issued between 2007 and 2012 face a similar fate.

Adding to the difficulties in assessing the riskiness of subordinated debt t in the post-crisis world, since 2010, Australian retail investors haven’t had the benefit of credit ratings on new subordinated debt issues to help gauge the extra risk they carry relative to the issuer’s senior debt, although issuers continue to get ratings for interested institutional investors.

APRA’s concern is ensuring that the market and financial industry are protected if another global financial crisis hit, said Janine Cox, investment analyst at Wealth Within. “So the way I see it is that the retail investor is secondary.”

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