All hail the bail-in?
“Bail-ins” allow distressed banks to write-off assets held by investors, including certain bonds. It’s no cause for panic, but Lysander’s Ian Marthinsen explains why it’s important to know what you own.
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The collapse of financial institutions such as Credit Suisse have many investors asking what would happen to their bank-issued bonds if their financial institution became insolvent. Not all bondholders are treated the same, says Ian Marthinsen, portfolio strategist with Lysander Funds Ltd., an experienced Canadian investment fund manager — so it’s important to understand what happens to certain assets during a bank failure.
In the wake of bank bail-outs following the 2008 financial crisis, regulators sought to find new instruments to rescue distressed financial institutions. Instead of relying on taxpayer-funded bail-outs, banks could seek relief through bail-ins borne by investors.
The concept of bail-in was central to the Basel III international regulatory accords and affects financial institutions identified as domestic and global systemically important banks (D-SIBs and G-SIBs). These banks would have to maintain a minimum amount of capital relative to their risk-weighted assets. Part of that capital reserve could be raised by issuing Additional Tier 1 bonds (AT1s), unsecured perpetual bonds that offer higher yields to compensate for their lower position in the bail-in capital stack.
“This is a layer of taxpayer protection against bank insolvency.” says Marthinsen. “Another objective of bail-in is to decrease the hazard for the big banks by letting them know their capacity for taking risks isn’t limitless. The government isn’t going to bail them out.”
In 2016, Parliament amended the Canada Deposit Insurance Corporation (CDIC) Act, authorizing the CDIC to recapitalize D-SIBs using certain investor assets.
In Canada the D-SIBs are the Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada (RBC) and Toronto-Dominion Bank (TD). Both RBC and TD are further identified as G-SIBs.
Canada assesses bank non-viability using a discretionary trigger, a process that begins with a non-viability opinion from the Office of the Superintendent of Financial Institutions (OSFI). European regulators also rely on discretionary triggers, but may also utilize mechanical triggers based on financial ratios. However, once a bank failure has been recognized, regulations determine which assets can be converted and to what extent.
The CDIC has determined that deposits — including chequing accounts, savings accounts and term deposits such as GICs — are not subject to bail-in. Neither are secured liabilities, such as covered bonds, eligible financial contracts, such as derivatives, certain structured notes, and short-term liabilities issued with less than 400 days to maturity.
On the other hand, Additional Tier 1 regulatory capital, also known as non-viability contingent capital (NVCC), is subject to bail-in as a regulator’s first recourse in the event of a non-viability bail-in trigger. In Canada, the AT1 category includes preferred shares and limited recourse capital notes.
“Being categorized as NVCC means conversion is first and is all or nothing,” Marthinsen says. “If a bank has issued $100 billion in AT1 bonds, but needs only $50 billion to recapitalize, regulations require that all $100 billion must be converted.”
That’s why investors in AT1 bonds issued by Credit Suisse, a G-SIB, saw all of their AT1 holdings wiped out.
After NVCC bonds are converted, senior unsecured bail-in bonds would be subject to bail-in next.
“These bonds sit above NVCC bonds in the capital stack and can be converted on a pro-rated basis, so they offer a little more risk protection for investors,” Marthinsen says. “If a bank has converted all of its AT1s, and still requires an additional $50 billion from $100 billion issued in senior unsecured bail-in bonds, then these bond holders would only lose half their investment.
The loss absorption mechanisms for bail-in bonds may differ from country to country. In Canada, senior bail-in bonds can be converted to equity, whereas in Europe they may also face either temporary or permanent write-downs. While neither scenario would be great, investors should have a preference to equity conversion over principal write-down. That’s massive dilution, however not a total write-off.”
Marthinsen points out that the bail-in loss absorption risks inherent in holding bail-in bonds are clearly spelled out for investors, so they can properly assess the benefits of choosing higher yields against the possibility of bank failure and the imposition of bail-in provisions.
“What happened with Credit Suisse isn’t a call to divest your portfolio of assets subject to bail-in,” he says. “It’s a reminder to apply due diligence and sit down with your financial advisor to review your portfolio. That should include the type of security that may be subject to bail-in and the health and jurisdiction of the financial institutions who issued them.”
Active managers, such as Canso Investment Counsel, the portfolio manager for certain Lysander Funds, also exercise the due diligence required to ensure adequate compensation for funds that include this type of asset.
Does the Credit Suisse bail-in herald the demise of the European NVCC market, given the recent precedent set by regulators?
“Banks need to hold AT1 assets, so we may see credit spreads widen to attract the required regulatory capital,” Marthinsen says. “That may lead to a more attractive market for investors who do their due diligence. That’s the free market at work.”
For more information on Lysander Funds, visit: www.lysanderfunds.com
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