Bank Hybrids – Still as safe as houses?

Clive Smith

Russell Investments

The Global Financial Crisis of 2008 (GFC) was a turning point for bank hybrid investors. Though most investors still focus on the traditional risks associated with bank hybrids, regulatory changes have not only altered the risks investors in hybrids are exposed to but also increased the total level of risk. 

Traditionally, investors in bank hybrids have viewed conversion risk as the major risk, driven by the potential for a major Australian bank failure occurring due to bad debts.  For a range of reasons such bankruptcy risks would appear to be quite low for Australian banks.   Firstly, both the banks and the banking regulator (Australian Prudential Regulatory Authority or APRA) have proactively sort to curb lending and manage exposures to residential property, due to the high-risk nature of this sector for potential bad debts.  Secondly, Australian banks are profitable, due not only to the current point in the credit cycle but also industry structure.  Finally, in comparison to some other global banking systems the Australian banking system is well capitalised, i.e. it possesses material capital buffers.  So overall everything is looking positive for investors in bank hybrids with the potential for materially higher returns with little in the way of conversion risk associated with the debt cycle.

Unfortunately, a focus on such risks ignores that the key factor driving the ongoing operation of any bank is access to liquidity to ensure ’day-to-day’ solvency.  While solvency can be linked to bank profitability and capital buffers, it is also quite distinct and can be impacted by other factors, some of which may be external to the domestic banking system.  Solvency risk accordingly deals with the ability of banks to have ongoing access to the funds necessary to finance their loan books.  Ongoing access to such funds becomes critical not only due to banks being highly leveraged but also because all banks borrow short-term and lend long-term (i.e. there is a duration mismatch between assets and liabilities).  Such a risk can be exacerbated by a bank having a higher proportion of their total funding coming from domestic/global debt and money markets rather than domestic deposits which tend to be stickier.  The impact of solvency risk was amply demonstrated by the GFC which threatened bank solvency globally and domestically via the freezing of the global interbank market.  It was only timely intervention by governments around the world, including the Australian government, which stepped in to guarantee bank debts, which ensured the ongoing solvency of the domestic banking system.  Importantly, events which impact upon the ability of banks to access capital markets can not only occur suddenly and without warning but may also be unrelated to the domestic credit or ‘bad debt’ cycle, i.e. can be driven purely by global events.

The increased significance of solvency risk to hybrid investors is due to regulatory changes in the decision structure regarding which party determines when the conversion of bank hybrids occurs.  Prior to the GFC, the process was clear cut in that conversion rested with the issuing bank.  However, over time APRA has moved to increase its power on when conversion occurs and can now require conversion to occur if, in their view, a bank becomes non-viable without (a) conversion of the hybrids or (b) in the absence of a public sector capital injection or equivalent support.  While there is little debating what constitutes an injection of capital by the public sector, what ‘equivalent support’ encompasses is intentionally more ambiguous.  Does a government guarantee of bank debt which is required to ensure banks can maintain ongoing access to capital markets, as occurred in the GFC, constitute ‘equivalent support’?  It is therefore important to recognise that the concept of ’non viability’ is vague and potentially covers a much broader range of eventualities.  More specifically, should temporary events require government intervention to maintain bank solvency then this could be sufficient for APRA to require conversion of hybrids.

This does not mean that bank hybrids are at risk of being converted in the near term.  Indeed, it would still require an extreme event to trigger conversion of bank hybrids.  However, investors need to recognise that the conversion rules have changed and that conversion under the current regulatory framework is more likely in the event of another major impact on bank solvency.  This highlights how the returns offered by bank hybrids can be materially higher than alternatives but recognise that the risks associated with such investments have also increased post 2008.

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Clive Smith
Senior Portfolio Manager
Russell Investments

Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...


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