S&P: Increasing bail-in risk drives change

Investors in hybrid capital instruments face increasing bail-in risk as regulators around the world expand their toolkits for dealing with future bank failures. Increased bail-in risk is what’s behind Standard & Poor’s Ratings Services’ recently updated criteria for bank hybrid capital instruments and here Michelle Brennan, S&P’s European Financial Services criteria officer and a key architect of the new criteria, explains the increased bail-in risk, how this has been factored into the criteria and the ratings implications.

On 18 September, Standard & Poor’s published its updated criteria for assigning issue credit ratings to bank hybrid capital instruments. This followed a request for comment and many months of market consultation around the proposed changes.

The changes reflect our view that the emerging global regulatory and legal environment leads to a greater risk of loss absorption by hybrid capital instruments — and therefore of D (default) issue credit ratings — than our previous criteria recognised.

As a result, we have adopted wider downward notching of the issue credit ratings on some hybrid capital instruments from the stand-alone credit profile or long term issuer credit rating on the issuer.

Regulatory reform agenda is driving increased bail-in risk

The evolving regulatory and legal frameworks for banking sectors around the world are the driving factor behind our changes. The broad themes of the global regulatory reform agenda are clear. Authorities expect bank regulatory capital instruments to fulfill their basic purpose of absorbing losses for a bank undergoing distress, a role that hybrid capital instruments did not always provide through the financial crisis. Many governmental authorities and regulators are also in the process of expanding bank resolution options, in many cases through encouraging the use of “bail-in” instruments, which will provide additional tools to deal with looming bank failures in order to preserve financial system stability and lessen the need for taxpayer-funded bailouts.

These themes are core concepts in the policy frameworks for bank capital and resolution policy frameworks promoted by the Basel Committee on Banking Supervision and the Financial Stability Board. At the same time, different jurisdictions are following somewhat divergent paths, reflecting a range of factors, including industry structure, policy preferences, and political will shaped by experiences of the financial crisis. These different jurisdictional approaches are reflected in the new criteria.

Key changes in the new rating approach

The revisions in our criteria are primarily focused on the heightened risk to holders of regulatory capital instruments, arising from the increased likelihood that the instruments will absorb losses as a bank progresses toward — but in advance of — a point of non-viability. This risk is especially prevalent in countries that have implemented, or are in the process of implementing, Basel III, where loss-absorbing hybrid capital instruments are expected to play a more significant role in recapitalisation of troubled banks than what occurred during the recent financial crisis. Potential routes of loss absorption include coupon non-payment, principal write-down, conversion into common equity, and distressed exchanges.

The main changes to the criteria include revised standard notching to take into account the heightened risk of loss absorption for regulatory Tier 1 hybrid capital instruments. This revised notching for coupon-deferral risk recognises the increased risk of loss absorption on Tier 1 instruments when capital levels approach specific capital triggers, or fall within the Basel III regulatory capital conservation buffers or other capital buffers that regulators may apply.

The new criteria also provides further clarity around how we apply notching for a range of other instrument features, such as the risk of conversion or write-down, including statutory mechanisms, and for proximity to going concern conversion or write-down triggers. We have provided further examples of circumstances where we could apply additional notches, such as contractual narrow earnings tests, payment clauses linked to distributable reserves, statutory restrictions, and other risks that the issuer’s stand-alone credit profile or the standard instrument notching do not otherwise address. Finally, we have provided further clarification around how we handle notching for non-operating holding company issues.

Ratings impact

Following publication of the new criteria, S&P updated its ratings on 1,871 bank hybrid capital instruments globally. Rating changes were communicated through a series of regional media releases, which can be found on the website listed at the end of this article.

We lowered the majority of issue credit ratings on hybrid capital instruments that are classified by regulators as part of Tier 1 regulatory capital. In addition, we lowered the ratings on instruments in jurisdictions where we anticipate that the statutory framework, including bank resolution regimes, would likely lead to the conversion of hybrid capital instruments and non-deferrable subordinated debt into bail-in capital as a bank approaches a state of non-viability.

Overall, we lowered by one notch the ratings on about 65% of the instruments within the scope of the updated criteria, and by two notches on about 15%.

Different jurisdictional approaches lead to different rating outcomes

The rating impact varied between regions and jurisdictions, reflecting notable differences in instrument features and in the expected behavior of the relevant regulators. The ratings impact in some instances also varied between legacy instruments and new instruments compliant with the Basel III framework.

For example, the high proportion of downgrades in Europe relates to the regulatory reform agenda, with bail-in mechanisms as a key element of the EU Bank Recovery & Resolution Directive (BRRD). In our view, these mechanisms will apply to legacy instruments as well as more recent issues. As a result, we applied a one notch deduction to European hybrids, due to the risk of conversion or write-down and reflecting the contingent capital nature of these instruments, whether the related mechanisms have a contractual or statutory basis, in addition to the additional notching to reflect Tier 1 status.

In contrast, our rating adjustments in the US were somewhat more incremental and reflected the expected impact of the Basel III capital conservation buffer mechanism on the risk of coupon non-payment (and hence of an issue default). Other jurisdictions show varying balances between downgrades and affirmations, reflecting the differing and largely moderate progress toward the implementation of regulatory reforms.

In sum, our updated criteria highlight the potentially significant differences in risk between bank hybrid capital instruments with different features. Of equal importance, we expect to factor into issue credit ratings under the criteria framework both gradual and sometimes rapid changes in bank credit quality that could have magnified impacts on hybrid instruments given their regulatory roles to absorb losses.

Further information

Visit S&P’s https://www.spratings.com/financial-institutions/banks/Hybrid-Capital.html hot topic at www.spratings.com where the new criteria, along with press releases, commentary, FAQ and short videos providing further background can be found.