After the 2008 international monetary disaster, the Financial institution for Worldwide Settlement (BIS) recognized larger capital adequacy for banks as an essential means to forestall systemic disaster.
Below the Basel III norms, banks are required to have larger capital relative to the dimensions of their threat weighed property.
The advanced Basel III framework permits devices/cash aside from fairness (Tier I) to even be counted as capital (below Tier II & Tier III), topic to situations. Perpetual, Non-Cumulative Choice Shares and Perpetual Debt Devices, also called Further Tier I or AT-1 bonds, emerged as devices to shore up Tier I capital of banks.
The difficulty of AT-1 devices by banks is ruled by a July 2015 RBI round. Its essential options embrace the loss absorbing capability of those bonds by way of conversion to fairness/write-off/write down, on breach of pre-specified set off level and on the level of non-viability; the latter as decided by the RBI. Caveats are required to be supplied to traders.
When it comes to seniority of declare, these unsecured devices are subordinate to the claims of perpetual debt, Tier II capital devices, depositors and basic collectors of financial institution however superior to claims of fairness holders. Nonetheless, write-down of fairness will not be required earlier than the write down of those bonds. AT-1 bonds have name choice on the finish of 5 years and supply yield of 200 to 300 bps larger than financial institution mounted deposits.
AT-1 bond is a debt instrument in regular occasions and takes the character of fairness in occasions of disaster, thereby, purportedly augmenting the fairness capital of banks once they want it most. However there are some issues with this premise.
In macroeconomic administration, counter cyclical insurance policies are often used to reasonable ‘boom-bust’ financial cycles. So when the economic system present indicators of heating there’s a tightening of insurance policies and when it slows down, accommodative insurance policies are used.
Nonetheless, the AT-1 bond is the antithesis of this, because it fuels pro-cyclicality. On this regard, it might be instructive to delve on leverage and its systemic influence.
At current, the yield on 10-year Authorities safety (G-Sec) is about 6 per cent. Nonetheless, by borrowing brief time period cash, say at repo charge of 4 per cent, the return on this G-Sec may be magnified considerably by way of leverage.
With 100 occasions leverage, the 10-year G-Sec, yielding about 6 per cent, may be made to provide a return on funding of 206 per cent! This ‘extra return’ by way of leverage will not be threat free as there’s a huge mis-match between the tenure of property on one hand and the tenure of legal responsibility on the opposite. If roll-over of the brief time period borrowing doesn’t occur for any cause, then the whole personal funds (fairness) is worn out immediately.
Systemic risk
This illustration will not be a mere theoretical assemble; it’s the build-up of such concerted leveraged positions of economic entities, albeit by way of advanced derivatives, and its inevitable collapse, that led to the 2007-08 international monetary disaster.
Leverage, due to this fact, will not be an entity particular threat however is systemic in its scope and influence. There are additionally limitations of the Basel framework in not factoring within the stage of leverage of the borrower i.e. the capital adequacy of banks..
AT-1 bonds by way of the framework of leverage, when the going is nice, AT-1 bonds are debt instrument and when there’s deterioration in financial institution’s capital adequacy, these bonds may be transformed to fairness or written off. Thus in good occasions, AT-1 bonds improve the leverage of the financial institution, boosting the return of the fairness holders, thereby engendering the increase or pro-cyclicality. By leverage, the advantages of upside are reaped by the fairness holders however the draw back is borne by or shared with these bond holders.
Subsequently, AT-1 bonds present perverse incentive for the fairness holders to undertake a excessive threat technique to spice up their return by way of this one-way wager. That’s precisely what occurred in YES Financial institution whereby 100 per cent of the AT-1 bonds of about ₹8,500 crore was written off as in opposition to 49 per cent of the fairness that was written off, in its March 2020 restructuring. The erstwhile promoter had additionally cashed out his total holding previous to the bursting of the bubble, whereas the choice to exit was not available to those bond holders because of illiquid secondary markets.
Defending retail traders
Whereas SEBI has proactively protected the retail traders by proscribing the direct availability of AT-1 bonds to them, these traders should have oblique publicity to this unique instrument by way of MFs, Pension Funds, Insurance coverage and so forth.
If the purpose was to boost capital of banks, then infusion of fairness is the most suitable choice. Nonetheless, rising leverage (by way of ‘refined’ AT-1 bonds) to boost banks’ capital, is eerily paying homage to the advocacy for rising arms gross sales to bolster world peace!
AT-1 bonds engender pro-cyclicality and if extensively used, has the potential to influence systemic stability. AT-1 bond is constructed on a conceptually flawed premise and deserves a revisit.
The creator works within the monetary sector. The views expressed are presonal