Do hybrid bonds actually offer depositors protection?

ANIL GUPTA

is senior vice president and cogroup head, Financial Sector Ratings, ICRA.

During the last few years, there have been a few instances of the writedown of debt capital instruments issued by banks in the Indian market—such as the Tier 1 bonds of Yes Bank in March 2020 and Tier 2 bonds of Lakshmi Vilas Bank in November 2020 after being declared non-viable by the Reserve Bank of India (RBI). Similarly, there have been precedents of the complete write-off of these instruments globally, the most recent being the Tier 1 bonds of Credit Suisse following its takeover by UBS.

Bondholders of Yes Bank’s Tier 1 instruments challenged the write-down and moved the judiciary on the matter. As they received a favourable judgement from the High Court of Bombay in January 2023, the bank, RBI and the government decided to move the Supreme Court of India against the order.

The matter remains sub-judice at present. The April 2024 order of the High Court of Madras has also directed RBI to take a fresh decision on the write-down of the Tier 2 bonds of Lakshmi Vilas Bank.

The financial strength of a bank in terms of safety is seen in how well capitalized it is. A rising capital adequacy ratio, for example, means a bigger capital base as a proportion of its risky assets (or loans). The bigger this cushion is, the more easily it can absorb losses. Sound banks tend to have more capital than required by regulation. It need not all be equity. RBI rules let banks issue debt instruments to fill capital cushions.

After the global financial crisis in 2008, the onus of bailing out failed banks in the West fell on governments. To address this, the Basel Committee of the Bank for International Settlements (BIS) notified new debt capital instruments. These instruments, namely Basel 3 Tier 1 and Basel 3 Tier 2 bonds, have a complete write-down feature to bail out a troubled bank if it is declared non-viable by the central bank that exercises jurisdiction over it.

These bonds are also known as ‘hybrid bonds’ as they have the features of debt as well as equity capital. Consider the risk of write-offs. In an event of stress, these bonds bear the brunt of value destruction even before the bank’s equity holders are called upon to take a loss, as per the terms of their issuance. This can lead to great losses borne by bondholders. In the Indian banking system, such debt capital instruments surpassed ₹4 trillion on 31 March 2024 (a fifth of the system’s net worth of over ₹21 trillion), with Tier 1 bonds accounting for around 30% of total outstanding debt capital instruments.

Over the last decade, the covenants for coupon payments on Tier 1 bonds have undergone a change to ease the ability of banks to service them. This has also improved investor appetite for these bonds, which can be serviced only through the profits or accumulated profits of banks. As some banks suffered huge losses during India’s last phase of asset quality stress (from 2015-16 to 2019-20), many banks, including public sector lenders, came close to skipping coupon payments on these bonds.

Nevertheless, with large capital infusions from the government, several public sector banks were able to service these bonds. Hence, while these bonds always had a write-down feature, the onus of bailing out these banks fell on the government. Subsequently, prior government approval was made a prerequisite for public sector banks to issue such Tier 1 bonds from January 2018 onwards.

These debt capital instruments usually promise higher yields on account of the greater risk of holding them. However, the attractiveness of their yield premium over safer bonds is debatable, given recent instances of such instruments being written down, or in the backdrop of the extraordinary financial support extended by the government even to the weakest public sector lenders.

The Supreme Court’s judgement on Yes Bank’s Tier 1 bonds will be under watch, as it will set a precedent for the fate of these debt instruments in future bank resolution cases. It could also offer clarity on the bank regulator’s jurisdiction over such matters. Clarity on these issues will be crucial not only for the regulator in performing its role, but also for investors in general of failed banks, as they would be better able to assess the liabilities they may need to take over while proposing a resolution.

In case the decision goes against such a write-down, it would give rise to the question of whether these hybrid bonds are good enough for inclusion in the capital count for compliance with Basel 3 guidelines. Another question would be whether these bonds offer depositors protection in the event of a bank’s failure. If these bonds cannot absorb losses, they are merely another form of borrowing, which means their inclusion in capital-ratio calculations will need to be reconsidered.

Despite these ambiguities, the regulatory stance of keeping the depositor’s interest paramount has ensured that people’s faith in the Indian banking system remains high. Going forward, perhaps it would be prudent if all stakeholders—including issuers, investors and the sector’s regulator—reach a consensus on the risks involved in the use of such hybrid bonds before letting them be counted as part of the capital stock of banks for regulatory requirements.

If not, we many need to consider further restrictions on the use of such instruments by lenders.

The issue needs

to be settled. At stake is their ability to absorb losses and act as capital cushions

for lenders