Loss absorption under bail-in

I recently did a post on a Discussion Paper setting out how APRA proposes to increase the Loss Absorption Capital (LAC) of Australian authorised deposit-taking institutions (ADIs). I came down on the side of this being a desirable (arguably necessary) enhancement of the Australian financial system but noted that the devil was in the detail. One of the issues discussed was the potential impact of the proposal on the statutory and contractual loss hierarchy that defines the sequence in which losses are absorbed by the capital of the bank in the first instance, and by more senior sources of funding in need.  

This post attempts to dig a bit deeper into this question to better understand how losses would be assigned under a bail-in scenario. It is a pretty technical point and possibly of limited interest but I wanted to make sure I had a good handle on how loss absorption plays out in the future. Read on or stop here.

Key points

  • The bail-in of selected, pre-positioned liabilities modifies the traditional loss hierarchy that applies in a liquidation scenario 
    • As a general rule, the absorption of losses is accelerated across all tiers of LAC
    • CET1 investors bear the loss via the dilution of their shareholdings as AT1 and Tier 2 are converted to common equity
    • AT1 investors risk not receiving distributions but otherwise the loss hierarchy between them and T2 investors seems to collapse once their holdings are converted into CET1
    • The only potential advantage to Tier 2 in these scenarios is that these instruments may only face partial conversion but how beneficial depends on the extent to which conversion to common equity offers a better chance to liquidate their holding versus selling the Tier 2 instrument itself into what is likely to be a very illiquid market
  • This has been increasingly true since APRA introduced Point of Non-Viability (PONV) conversion triggers in 2013, and the instruments without this contractual feature progressively matured, but the proposed expansion of the pool of LAC takes us further down this path:
    • partly by virtue of making it easier for APRA to restructure bank capital structures without recourse to taxpayer support (i.e. the odds of bail-in being used in a future crisis are increased if the tool itself is more effective); and
    • partly by increasing the quantum of CET1 dilution that is the mechanism by which losses are allocated to the various tiers of LAC
  • Investors in the various capital tiers will obviously adjust the return they require for the risks they are asked to bear but we should ensure we all have a clear and consistent understanding of how the loss hierarchy is modified, and whether the resulting loss hierarchy is desirable (or indeed equitable)
  • The answer to this question turns in part on whether the outcomes for AT1 and T2 investors are better or worse than the market value they could achieve if they sold their investments prior to bail-in 

Loss Hierarchy – the simple version

Prudential Standard APS 111 (Capital Adequacy: Measurement of Capital) defines the order of seniority amongst the three tiers of prudential capital:

  • CET1 Capital “… rank behind the claims of depositors and other more senior creditors in the event of a winding up of the issuer ” (Para 19 (d))
  • AT1 Capital “… rank behind the claims of depositors and other more senior creditors in the event of a winding up of the issuer” (Para 28 (c))
  • Tier 2 Capital “represents, prior to any conversion to Common Equity Tier 1 … the most subordinated claim in liquidation of the issuer after Common Equity Tier 1 Capital instruments and Additional Tier 1 Capital instruments (Attachment H, Para 1 (b))

APS 111 (Attachment F, Para 10) also explicitly allows AT1 instruments to 1) differentiate as to whether the instrument is required to convert or be written-off in the first instance, and 2) provide for a ranking under which individual AT1 instruments will be converted or written-off. The guidance on Tier 2 is less explicit on this point but there does not seem to be any fundamental reason why a bank could not introduce a similar ranking within the overall level of subordination. I am not aware of any issuer using this feature for either AT1 or T2.

If we ignore for a moment the impact of bail-in (either by conversion or write-off), the order in which losses are applied to the various sources of funding employed by a company follows this loss hierarchy:

  • Going Concern:
    • Common Equity Tier 1 (CET1)
    • Additional Tier 1 (AT1)
  • Insolvency – Liquidation or restructuring:
    • Tier 2 (T2)
    • Senior unsecured
    • Super senior
      • Covered bonds
      • Deposits
      • Insured deposits

CET1 is clearly on the front line of loss absorption (a perpetual commitment of funding with any returns subject to the issuer having profits to distribute and the Capital Conservation Ratio (CCR) not being a constraint). AT1 is subject to similar restrictions, though its relative seniority does offer some protection regarding the payment of regular distributions.

Traditionally, the claims the other forms of funding have on the issuer are only at risk in the event of the liquidation or restructuring of the company but bail-in modifies this traditional loss hierarchy.

What happens to the loss hierarchy under bail in?

First up, let’s define bail-in …

A bail-in is the rescue of a financial institution that is on the brink of failure whereby creditors and depositors take a loss on their holdings. A bail-in is the opposite of a bailout, which involves the rescue of a financial institution by external parties, typically governments that use taxpayers money.” (Investopedia)

Investopedia’s definition above is useful, albeit somewhat generic. Never say never, but the loss hierarchy employed in Australia, combined with the fact that there are substantial layers of more junior creditors for big banks in particular, means that most Australian depositors (even the ones that do not have the benefit of deposit insurance) are pretty well insulated from bail-in risk. Not everyone would share my sanguine view on this question (i.e. the limited extent to which deposits might be bailed in) and some countries (NZ for example) quite explicitly choose to forego deposit insurance and move deposits up the loss hierarchy by ranking them equally with senior unsecured creditors.

The main point of bail-in is that existing funding is used to recapitalise the bank, as opposed to relying on an injection of new capital from outside which may or may not be forthcoming. It follows that pre-positioning sufficient layers of loss absorption, and making sure that investors understand what they have signed up for, is critical.

AT1 has always been exposed to the risk of its distributions being cut. This sounds good in theory for loss absorption but the size of these potential capital outflows is relatively immaterial in any real stress scenario. It could be argued that every dollar helps but my view is that the complexity and uncertainty introduced by making these distributions subject to the Capital Conservation Ratio (CCR) outweigh any contribution they might make to recapitalising the bank. The people who best understand this point are those who have had to calculate the CCR in a stress scenario (you have to get into the detail to understand it). The CCR issue could be addressed by simplifying the way it is calculated and I would argue that simplicity is always a desirable feature of any calculation that has to be employed under conditions of stress and uncertainty. The main point however is that it does very little to help recapitalise the bank because the heavy lifting in any really severe stress scenario depends on the capacity to convert a pool of pre-positioned, contingent capital into CET1.

APRA has had explicit power to bail-in AT1 and T2 since the January 2013 version of APS 111 introduced Point of Non-Viability (PONV) conversion triggers – these enhanced powers do a few things:

  • The impact of losses is brought forward relative what would apply in a conventional liquidation or restructuring process
  • For CET1 investors, this accelerated impact is delivered via the dilution of their shareholdings (and associated share price losses)
  • In theory, conversion shields the AT1 investors from loss absorption because they receive common equity equivalent in value to the book value of their claim on the issuer
  • In practice, it is less clear that the AT1 investors will be able to sell the shares at the conversion price or better, especially if market liquidity is adversely impacted by the events that called the viability of the issuer into question
  • The conversion challenge will be even greater to the extent that T2 investors are also bailed-in and seek to sell the shares they receive

Tier 2 will only be bailed-in after AT1 bail-in has been exhausted, as would be expected given its seniority in the loss hierarchy, but it is hard to see a bail-in scenario playing out where the conversion of AT1 alone is sufficient to restore the viability of the bank. AT1 is likely to represent not much more than the 1.5 percentage points of RWA required to meet minimum requirements but any crisis sufficient to threaten the viability of a bank is likely to require a much larger recapitalisation so full or partial conversion of T2 should be expected.

Partial conversion 

Attachment J – Para 6 provides that “Conversion or write-off need only occur to the extent necessary to enable APRA to conclude that the ADI is viable without further conversion or write-off”. Para 8 of the same attachment also specifies that “An ADI may provide for Additional Tier 1 Capital instruments to be converted or written off prior to any conversion or write-off of Tier 2 Capital instruments”.

This makes it reasonably clear that APRA will not automatically require all AT1 and Tier 2 to be converted or written-off but the basis on which partial conversion would be applied is not covered in the discussion paper. A pro-rata approach (i.e. work out how much of the aggregate Tier 2 is required to be converted and then apply this ratio to each  individual instrument) seems the simplest option and least open to legal challenge but it may be worth considering alternatives.

Converting the Tier 2 instruments closest to maturity in particular seems to offer some advantages over the pro rata approach

  • It generates more CET1 capital than the Tier 2 foregone (because the Tier 2 capital value of an instrument is amortised in its final 5 years to maturity whereas the CET1 capital created by bail-in is the full face value off the instrument)
  • It defers the need to replace maturing Tier 2 capital and maximises the residual pool of LAC post bail-in.

What is the reason for the 20% floor that APS 111 imposes on the conversion price?

The transition to a bail-in regime may be an opportune time to revisit the rationale for placing a floor on the conversion price used to convert AT1 and Tier 2 into common equity. Attachments E and F contain an identically worded paragraph 8 that requires that the share price used to calculate the shares received on conversion cannot be less than 20% of the ordinary share price at the the time the LAC instrument was issued. This floor arguably requires the share price to fall a long way before it has any effect but it is not clear what purpose is served by placing any limit on the extent to which common equity shareholders might see their holdings diluted in a non-viability scenario.

Bail-in via write-off of AT1 or T2

I am concentrating on bail-in via conversion because that seems to be the default loss absorption contemplated by APS 111 and the one that is most consistent with the traditional loss hierarchy. LAC instruments can be designed with write-off as the primary loss absorption mechanism but it is not clear that any issuer would ever choose to go down that path as it would likely be more expensive versus bail-in via conversion. The write-off option seems to have been included as a failsafe in the event that conversion is not possible for whatever reason.

Conclusion

The loss absorption hierarchy under a bail-in based capital regime is a bit more complicated than the simple, progressive three tier hierarchy that would apply in a traditional liquidation scenario. I believe however that this added complexity is justified both by the enhanced level of financial safety and by the extent to which it addresses the advantage big banks have previously enjoyed by virtue of being Too Big To Fail.

The main concern is that AT1 and Tier 2 investors who underwrite the pre-positioning of this contingent source of new CET1 capital properly understand the risks. I must confess that I had to think it through and remain open to the possibility that I have missed something … if so tell me what I am missing.

Tony

 

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

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