Nevertheless, resulting political concerns about moral hazard as well as strains on sovereign balance sheets have spawned numerous regulatory initiatives seeking to minimise reliance on government support in future crises.
The main focus of these regulatory efforts, including the ongoing Basel III reforms, has been to strengthen bank capitalisation. Another prominent initiative is burden-sharing, or the process whereby uninsured creditors must first bear losses before public sector capital support is provided.
Legislative uncertainties and implementation challenges make it difficult to forecast whether burden-sharing will ultimately come to pass. For burden-sharing to work in practice, the contractual terms of loss-sharing instruments cannot impede the institution's ability to operate on a 'going concern' basis. Indeed, pre-existing terms of subordinated debt and hybrids (including must-pay features and potential events of default from non-payment) were largely responsible for these instruments not functioning as risk capital during the crisis.
Other challenges to burden-sharing include the complexity of resolving cross-border banking groups and the difficulty in imposing losses on investors without sparking broader contagion.
Risk profile
It is hard to predict the regulatory outcome. However, if burden-sharing were implemented, then the risk profile of different classes of bank obligations could change markedly, with subordinated debt and hybrid securities exposed to much higher credit risk in the future. Senior debt would be moderately impacted, but might incur losses under severe stress scenarios.
What leads us to this conclusion? First, in an interesting coincidence, the outstanding amount of hybrid and subordinated debt securities of the top 100 banks globally totalled approximately $1200bn in the initial phases of the crisis (fiscal year-end 2007), which would have covered most of the $1300bn capital support subsequently provided by governments. While these securities are not fungible in absorbing losses across institutions, the aggregate stock of subordinated debt and hybrids could provide regulators with much of the capacity needed to recapitalise major banks worldwide in a future downturn.
Stress tests
Additionally, Fitch has performed stress tests of banks' capital structures under an adverse scenario that is grounded in, but more severe than, the recent crisis. This stress test consists of an assumed 5% loss rate applied to the net loans and securities (excluding derivatives) of more than 40 of the largest global financial institutions. This severe scenario results in a tangible common equity (TCE) ratio of -1% for the sample as a whole. While some institutions would remain solvent (achieving positive TCE), only three would maintain TCE ratios above 2% after incurring a loss of this magnitude.
However, if we now assume in this example that the subordinated debt and hybrids of these institutions were convertible to equity, then the aggregate TCE ratio would rise from -1% to approximately 2.3%. Thus, if burden-sharing were imposed on junior creditors, the overall capitalisation of this group of banks strengthens considerably, all but a handful remain solvent and nearly two-thirds retain TCE ratios above 2%. In the process, the risk profile of hybrids and subordinated debt would increase dramatically, absorbing the 1% of loss not covered by TCE, with the remaining portion now functioning as risk capital. An important caveat to this analysis is that, within holding-company or complex banking group structures, capital held at the subsidiary level is in many cases trapped and thus unavailable to absorb losses across the organisation as a whole. Nevertheless, this example illustrates the consequential impact of equity conversion during a crisis.
Elevated credit risk
Interestingly, credit markets do not appear to be factoring in the potentially elevated credit risk of banks' subordinated debt and hybrids under a burden-sharing regime. For example, hybrids pricing has recovered significantly since the depths of the crisis. This rebound might also reflect market scepticism about the likelihood of burden-sharing being implemented or the view that only new issuance would be affected.
While there is no private sector alternative to both the resources and the confidence provided by government support, burden-sharing might dramatically reduce the role of publicly financed recapitalisation in the future.
Robert J Grossman is group managing director and Martin Hansen is a senior director of Fitch Ratings' research group, based in New York. Fitch Ratings' special report, 'Burden-sharing: who pays next time?', is available on www.fitchratings.com
