A Basel proposal for subordinated debt to absorb losses if a bank is about to fail could overturn risk profiles, raise the cost of capital for banks and curtail issuance of subordinated instruments. Writer Geraldine Lambe

Click here to view an edited video of Geraldine Lambe talking with Editor, Brian Caplen on the issue.

What is it?

A consultative document on the loss absorption of capital instruments. It proposes that subordinated debt provide a capital buffer at an earlier stage to prevent the need for government capital injections. The idea is to end the notion of 'too big to fail', level the playing field between big and small banks, and reduce moral hazard, under which bondholders rely on government support to avoid losses.

Who dreamed it up?

The Basel Committee on Banking Supervision.

What are the main provisions?

That all regulatory capital instruments (including dated subordinated debt classified as lower Tier 2) issued by banks will absorb losses if a bank is deemed non-viable. The committee proposes that the trigger for non-viability would be the earlier of: the decision to make a public sector injection of capital without which the firm would become non-viable; or the decision that a write-off is necessary, without which the bank would become non-viable. The proposal lists three ways in which capital instruments could absorb losses: via permanent write-off; via a conversion into common shares; or a combination of the two - a write-off fully or partly compensated by an issue of shares. So far, the committee has made no proposal on the terms of the conversion or how it might vary between banks or between instruments. It looks likely that this would be left to the market, with banks and investors deciding on the trade-off in each new issue between the pricing of bonds and the generosity of conversion terms.

What's in the small print?

It is more a case of what is not in print. The proposal does not mention loss absorption via deferral of interest payments - the usual way in which Tier 1 instruments absorb losses. Nor does it take into account the fact that bondholders can take significant losses on their holdings - through mark-to-market write-downs or via distressed exchange or buyback offers. Instead, rather than wait for a bank to fail (when these instruments would become fully loss-absorbing), or to be rescued by government capital injection (which protects debt-holders), the proposal suggests treating a bank as a 'gone concern' if it would, in the regulator's opinion, have failed without government support. The proposal in some ways reverses the risk profile of debt and equity. While a capital injection from the government would dilute existing shareholders, Tier 1 and Tier 2 instruments could potentially be written off - even if there were not a government capital injection. The committee says "a write-off can be viewed as a transfer of wealth from the instrument holder to the common shareholders", as the net assets to which the shareholders have a claim grow.

Watch the video 

Editor Brian Caplen talks to Geraldine Lambe, capital markets & investment banking editor, about the Basel Committee's proposal to make lower Tier II and subordinated debt loss absorbing before a bank becomes non-viable

What does the industry say?

Some bankers believe this could signal the death knell for lower Tier 2 capital and could severely curtail issuance of other subordinated instruments. "This will make subordinated debt more risky and more expensive," says one banker. Moreover, he argues that the proposal will fail to level the playing field between banks. "Despite the proposal, the bigger a bank is, the less it will pay for subordinated debt compared with smaller competitors," he says. Others worry that leaving the market to decide the terms of bonds on an issue-by-issue basis could mean that we end up with investors not being sure what they are buying.

How much will it cost?

"Whichever way you look at it, it will significantly increase banks' cost of capital," says John Raymond, senior analyst at independent research house CreditSights. "It will push up the cost of subordinated debt closer to the cost of equity. If banks rely on debt markets for funding, they can make the terms more attractive regarding share conversion, etc; but the more they risk diluting shareholders, the more upwards pressure they will put on the cost of equity."

The law of unintended consequences

Or is that 'intended' consequences? Many believe that a new investor base prepared to take risk will have to be found - and that could be hedge funds. Will regulators want this new constituency? Maybe, says Mr Raymond. "Basel wants sub-debt investors to act as a check on bank management in the same way as shareholders, so a smaller base of more activist investors could fulfil that role," he says. "To get hedge funds to buy such instruments, banks may have to significantly increase disclosure," says Mr Raymond, "and that would fulfil another of Basel's aims."

Could we live without it?

We could, but it is unlikely that regulators will do nothing about capital instruments. It is widely believed that bondholders got off very lightly during the financial crisis - and policy-makers want them to take some of the pain.



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