Is all bank debt equal? And why does this matter?

Is all bank debt equal? And why does this matter?

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Article highlights

  • Bank assets are cash, government securities and various types of loans offered by the bank that earn interest
  • All types of debt issued by a counterparty will be ranked differently according to the risks rooted in these assets
  • The bank's capital structures comprises of multiple types of debt with different levels of seniority

Income type fund fact sheets prominently publish the funds’ exposures to banks. Most investors have a tendency to treat debt issued by a bank as uniform – which begs the question: “Is all bank debt issued by a single banking entity equal?”  

It’s a simple question but understanding the nuances of the answer has become crucial for investors in the current environment and as a result of pending regulation. To answer, we must begin by looking at the concept of leverage.

How does leverage work?

The concept of leverage is essential to banks. In contrast to industrial companies, banks need to be highly leveraged in order to generate an acceptable rate of return. 

To see how this works, consider two separate banks, BANK A and BANK B. Each of these banks has R100 in assets, a deposit rate of 2%, and a lending rate of 3%. 

• BANK A funds its operations solely using its own equity, earning a pre-tax Return on Equity of [100 x 0.03] / 100 (equity) = 3%.  Hence, BANK A is unable to generate returns above its lending rate for shareholders if it funds its business entirely with equity. 
• BANK B however, funds 90% of its operations through lower cost deposits or other liabilities so that the required equity is only the amount necessary to protect depositors, offset losses, and enable adequate returns to be made to shareholders.  This allows for a pre-tax Return on Equity of [90 x (0.03-0.02) + 10 x 0.03] / 10 (equity) = 12%. 

Hence, BANK B is able to earn a higher pre-tax Return on Equity by using leverage. The downside to leverage is that it increases the risk of a bank.  The market recognizes this risk, and investors will require a premium over their invested capital if a bank is too highly leveraged. Therefore, it might benefit a bank to hold a higher than required amount of capital, signalling confidence to the market and in turn potentially lowering its funding costs.

Understanding bank capital

From an accounting point of view bank equity is simply the bank’s assets less its liabilities.  Bank assets are cash, government securities and various types of loans offered by the bank that earn interest (eg. home loans, personal loans, vehicle financing).  Bank liabilities are any loans or debt obtained by the bank, including deposits by customers.  Bank capital consists of equity and it includes some loss-absorbing liabilities such as Tier 2 and Tier 1 paper.  Bank capital is a regulatory term and it is governed by Basel 3 as well as SARB regulation.  Bank capital is considered from a regulatory point of view as the “equity” in the bank (also known as the net worth of the bank) and therefore it is important to investors because it acts as a reserve against unexpected losses. It also protects creditors if the bank were to go into liquidation.   

Bank capital is a regulatory concept that represents the value of a bank’s instruments that are loss absorbing and that have the lowest payment priority in an event of liquidation.

Basel 3 and the focus on bank regulatory capital was born out of the 2008-2009 Global Financial Crisis.  In the aftermath of a recession that almost brought the world to its knees market reforms were being called for, not least from hardworking citizens who helplessly witnessed their invested assets vanish. 

Various research has shown how capital affects a bank’s chance of survival and market share, and how this varies across different phases of economic cycles.  In a nutshell:
(1) capital enhances the profitability of small banks at all times (during crises and normal times), and;
(2) capital improves the profitability of medium and large banks during crises.

Bank creditor hierarchy – why all debt isn’t the same

At this point, it is important to recognise debt heterogeneity in a bank’s capital structure.  All types of debt issued by a counterparty will be ranked differently according to the risks rooted in these assets - such as how much the debt holders may lose in a credit event, or potentially, even prior to any credit event.   The figure below shows hierarchy of bank creditors.  The contractual or legal liability structure (seniority) determines how a bank’s assets and cash flows will be distributed upon default to its creditors. 

Simplified bank creditor hierarchy in event of liquidation

Source: Taquanta Asset Managers

Equity holders bear the most risk in the bank.  Equity holders in a bank are entitled to profits and have unlimited growth potential.  Debt holders are exposed to limited upside while being exposed to default risk.  It is for this reason that debt holders rank above equity holders.  That said, banks have a complex capital structure.  This means their capital structures comprises of multiple types of debt with different levels of seniority.  It is therefore important for investors to know where their investment lies in the priority of payments. 
Because banks are subject to regulation which requires them to hold excess amounts of capital to mitigate operational risks, they issue additional Tier 1 and Tier 2 instruments which are classified as regulatory capital.

So, what should you look for?

Many phrases are used when identifying seniority but the most common and obvious term to look out for is “subordinated”.  The term “subordinated’ means the debt you are holding ranks below more senior debt and is therefore riskier.  As a result of this higher risk, these instruments will pay investors a higher rate of return.  It is important for prudent investors to understand a bank’s capital structure to help justify the risk and return inherent in a fixed income investment and price appropriately. 

Most common wholesale debt instruments issued by South African banks

Senior Bonds
Senior unsecured bonds are a popular debt instrument issued by the banks.  As the name suggests, senior unsecured bonds are not backed by any collateral.  Examples of these assets are bank issued fixed and floating rate notes and negotiable certificate of deposits (NCDs).  They rank slightly beneath bank deposits and senior secured bonds.  It is worthwhile to know that banks in SA are not currently allowed to issue senior secured bonds or “covered” bonds because they would subordinate depositors.  SA banks will only be allowed to issue these types of instruments once Depositor Insurance/Protection is in place). 

Subordinated Bonds
Subordinated bonds do not have collateral and are the lowest priority.  These bonds usually have an estimated loss given default (LGD), a calculation that estimates how much of the original investment an investor may lose in a credit default.  The Basel Regulations require banks to hold a certain level of capital post the Financial Crisis of 2008.  This capital acts as a cushion in a credit crisis.  This capital is ranked in order of priority, with Tier 1 (Common equity Tier 1 and Additional Tier 1) being most risky followed by Tier 2 capital. Basel III requires banks to hold about 10.5% of capital and this can be increased to 13% by adding a countercyclical buffer.

Tier 2 Bonds (T2 bonds)
A T2 bond has a fixed repayment date.  These instruments are usually callable by the issuing bank after 5 years.  If the issuing bank does not call these instruments, the investor will be required to hold these bonds for another 5 years.  The intention of the bank is usually to call these instruments as their contribution to capital amortises by 20% p.a. after the call date; however, it is at the bank’s discretion (subject to approval by the SARB).

Additional Tier 1 Bonds (AT1 bonds)
An AT1 bond has no fixed repayment date.   In other words, the instrument you are holding is perpetual.  The bank may decide to repay (call) the AT1 bonds at their nominal amount on the first call date, which must be at least 5 years after issuance (or on subsequent call dates).  The AT1 bonds can be called at any time following the occurrence of certain tax events as specified in terms and conditions for the AT1 bond or in the event that the entire nominal amount of the AT1 bonds fully ceases (or would fully cease) to be part of the bank’s Tier1 capital.  Call price will typically be at par. Coupons are non-cumulative, paid at the issuer’s discretion and can become restricted when the issuer’s capital falls below a certain level.

So, what we’re saying is…

At the end of the day, risk is directly correlated to the return i.e. the holder of a riskier asset wants to be compensated for additional risk.   This is illustrated very simply below.

Comparison of bank spreads for senior unsecured floating rate notes versus subordinated floating rate notes at issue date
Source: Standard Bank Research

Looking forward: what happens if a bank fails?

Currently the Insolvency Act does not provide for a granular enough hierarchy amongst bank creditors.   That means there is no legal basis in which certain bank creditors (e.g. junior and senior unsecured creditors) are differentiated in a liquidation scenario.  This lack of hierarchy makes it hard to enforce a bail-in sequence, even if the Resolution Authority (RA) is provided with explicit bail-in powers.  As a result of this, a Resolution Framework to deal with this issue which will come into effect in the next few years.  Refer to Figure 2 for the proposed bail-in sequence being looked at currently by the banking industry in South Africa and abroad.

Proposed Resolution Framework - Protection of depositors in the event of a bail-in
Source: Standard Bank Research

The resolution procedure is triggered when a bank is failing or is likely to fail.   It will make specific proposals on a minimum creditor hierarchy, which should serve as a guide to the bail-in sequence.  “The bail-in tool will therefore give shareholders and creditors of institutions a stronger incentive to monitor the health of an institution during normal circumstance” .  The too-big-to-fail burden will no longer fall on taxpayers as it did in the 2008-2009 Financial Crisis! 

The take out

Understanding the difference between a bank issued instrument’s capital ranking to price the risk and assess the relative liquidity of each instrument under various market scenarios, is going to become increasingly important to investors. And not all paper issued by any particular bank is equal.

Taquanta Fixed-Income Team
Best of Breed Manager of the Nedgroup Investments Cash Solutions fund range