About a fortnight ago Kiwibank announced that its formerly disqualified capital instruments now re-qualify as capital. Yay! This after a the capital disqualification event on which I wrote not so long ago.

There was almost no press coverage of the re-qualification. Yes, there was NBR’s Jenny Ruth who wrote a noisy and non-informative story on the reinstatement, but she left her readers in the dark about the capital flip-flop.

My 2 cents: it is not that difficult to figure out the main issue here. Just look at the press release of Kiwibank of 10 August, which mentions: “Having now given due consideration to the changes that were made and accepting that Kiwibank should not consolidate KCFL, the RBNZ has today issued a new notice of non-objection in relation to the Kiwibank Bonds.”

Compare this to the RBNZ requirement covering issuance of capital instruments out of an SPV: “In order for a capital instrument issued by an SPV to third party investors to qualify as regulatory capital, the following criteria must be fully satisfied: (a) The SPV issuing the instrument is a fully consolidated subsidiary of the registered bank.” (The Banking Supervision Handbook, Subpart 2G – Capital instruments issued by special purpose vehicles, emphasis added).

The result of consolidation when done properly is that the parent bank and third party investors can ignore the internal on-loan: the instrument that Kiwibank issues to the SPV thus becomes a black box. See the lower part of the graph:This will work if the indirectly-issued instrument complies with the conditions for qualification as capital: as if the SPV were itself to include the instrument as capital. The on-loan and the capital instrument in the graph above should be equivalent, except for, for example, voting rights.

In addition, these EBA guidelines on hybrid capital reveal important requirements regarding SPV issuance: “Investors in the instrument shall retain at least the same degree of subordination in insolvency and on an ongoing basis, as if the instrument was issued directly by the parent. Guarantees from any other part of the group shall not be given that afford hybrid investors a preferential claim and shall not, as a result, allow acceleration of repayment to investors.”

I asked an auditor/partner of a Big-4 audit firm, an investment banker with many years of experience on capital instrument issuance, and a specialized lawyer about their views on the de-consolidation requirement of the Kiwibank capital instruments. All three of them came up with the view that I summarize as follows: “The instrument that the supervisor is evaluating is the on-loan. De-consolidation renders the SPV into a re-packaging vehicle, perhaps because some guarantees were offered that compromise the loss absorbing capacity of the instruments involved. Consequently, the full risks of the SPV are now imposed on the investors. The Reserve Bank appears to be comfortable with the reputational risk post de-consolidation.

Interestingly, regarding their latest position on the Kiwibank instruments, the Reserve Bank seems to rely on accounting standards that are complex and subject to interpretation (IFRS 10, IFRS 12, and SIC12). At the same time its second Capital Review Paper expresses the desire to clarify the banking group definition.

Watch that space.