The origins of this new bond category :
In the wake of the financial crisis of 2008-09, international regulators decided that banks should have their own capital buffers to absorb any losses. These buffers would serve as shields against risk in order to protect taxpayers who had largely contributed to the bail-out of banks during this period.
Subsequently, the Financial Stability Board, an international regulator, created a ratio: the TLAC (Total Loss-Absorbing Capacity). It defines the capacity of a bank to absorb financial losses in the event of a crisis. The buffer, comprising capital and similar instruments, would represent 16% of their total risk-weighted assets (RWA), i.e. much higher than the level stipulated in Basel III (8%). In 2022 this capital buffer will be raised to 18%.
The TLAC ratio must be implemented between 1 January 2019 at the earliest and 2022 by the world’s 30 banks considered as global systemically important banks (including 4 in France: BNP Paribas, Crédit Agricole, BPCE and Société Générale). Today, bail-ins are favoured (in the context of the 2015 bail-in law).
Europe also decided to adopt its own measure for absorbing losses: the MREL (Minimum Ratio of Eligible Liabilities). It still needs to be fine-tuned and the regulator is seeking to harmonise measures for bailing out banks across Europe (differences exist between Germany, France and Italy). The ratio incorporates the TLAC standards in addition to new requirements for what the cushion must consist of.
How will these protection mechanisms work?
Serving as a protection, these cushions will be made up of core equity capital (CET1), hybrid capital instruments (AT1 and Legacy Tier 1), other subordinated debt (Tier 2, Lower Tier 2, Upper Tier 2) and finally, certain senior debt securities which are structurally junior compared with other liabilities (the new Tier 3 notes). Losses will be borne according to the rank of seniority of these notes (i.e. the riskiest will be the first to take losses).
If a bank faces serious difficulty (to avoid bankruptcy and favour business continuity), its capital will be impacted initially. The next stage is that coupons will not be paid on the AT1. Finally, losses will be taken according to a ranking structure, from the AT1 to the Tier 3, depending on the amount of losses to be allocated. In other words, there is a substantial cushion well before the Tier 3 bonds are penalised by losses.
The case of French banks:
France took the lead with the TLAC/MREL solution by implementing an EC directive: the Sapin 2 law was published in the JO (official journal of the French Republic) on 10 December 2016. It authorises French banks to issue new bonds representing debt that can absorb losses, if need be. They are also known as Non Preferred Senior (NPS) or Tier 3.
These bonds have the status of senior debt but are nevertheless more risky than traditional senior debt. They are considered as “junior” senior debt, because in the event of default, priority for repayment is given to traditional senior debt.
These notes do not replace senior debt but make up an additional layer in the hierarchy of creditors.
Features :
- To be eligible for TLAC/MREL ratios, Tier 3 bonds must have a residual maturity of one year. Therefore, to be eligible on 01/01/2019, Tier 3 bonds issued today must not come due before 2020 at the earliest.
- The rating of these instruments is on average 2 notches below the senior rating at S&P (only one notch below for BNP Paribas). At Moody’s, the rating is 3 notches below the senior rating.
- The credit spread is on average 60bps higher than the yield on the senior debt of the same issuer.
- No call date (the securities are known as “bullet”).
- The rating of these instruments is on average 2 notches below the senior rating at S&P (only one notch below for BNP Paribas). At Moody’s, the rating is 3 notches below the senior rating.
Tier 3 bonds: a very young market
In France:
Recent issues (Crédit Agricole London, BNP Paribas, Société Générale) show that these securities are liquid (the spread between the bid/ask price is 12bps, jumbo bonds).
Demand was stronger because in the end, the credit spread was narrower than initially estimated. Demand came mainly from institutional investors who found an attractive additional return for an additional (very low) risk, in view of the quality of the issuers and the rating of these bonds (A-/Baa2 for the Tier 3 of BNP Paribas).
In Europe:
Spain will probably choose the same solution as France by creating a new category of “senior junior” bonds (also known as Tier 3, as in France). However, there are still differences among countries in Europe.
In Germany, all existing (not yet matured) senior bonds issued by German banks are now considered as securities that can absorb losses from their issuer. There was no creation of a new category of senior debt, like in France or in Spain, where the objective was not to penalize the holders of current senior bonds. The holders of bonds issued by German banks are today exposed automatically to higher risks, which was not their choice when they initially bought these bonds.
The UK and Switzerland have decided to let their banks issuing bonds from their holding (Holdco bonds). All UK and Swiss banks are split into a holding (the Holdco) and an operational subsidiary (the Opco). Senior bonds issued at Holdco level are riskier for holders and show features close to Tier 3 paper.
Other countries in the eurozone like Belgium or Italy have not yet decided on the final format for their “senior junior” bonds.
Thierry Trigo