An evaluation of RBNZ’s hybrid capital securities

Will the RBNZ’s latest innovation on bank capital, the Redeemable Perpetual Preference Shares, contribute to more and better bank capital? The analysis below casts doubt on the success of RBNZ’s attempt to help New Zealand banks to issue capital at a low cost. A victim of its own cakeism, the RBNZ instead created a hybrid capital security that resembles cheap filler more than an instrument that contributes to financial stability.

It looks like the desire to not lose face motivated the RBNZ to craft a low-cost and low-quality capital security. This to please the banks and compensate them for being subjected to exceptionally high capital requirements. As such, political considerations prevailed, hence the title of this blog post.

A volte-face

Just before the Christmas break, the RBNZ published the decisions it made about New Zealand bank capital. An important decision pertained to the types of capital that qualify as true bank capital. In a last-minute volte-face, the RBNZ decided to accept as Tier 1 capital a complex and low-cost security that could be used as a substitute for expensive equity capital. The name of this security: Redeemable Perpetual Preference Shares, or RPPS. Banks can now use $9 billion of these RPPS securities to meet the new and high capital requirements, which amount to $20 billion in total. No small fry!

Four important benchmarks

Given the amounts involved, it is important to assess the quality of RPPS securities. Do we all believe they absorb losses when a bank gets into trouble?

To answer that question, one should realise that any investor and any issuing bank dealing with non-equity bank capital securities wants to know:

1. if the tax authorities accept these securities as debt. If so, the payments on these securities are tax deductible. This is the most important benchmark. Because, in practice, tax savings are the only reason to issue non-equity capital securities.
   
2. if the securities are capital under the relevant prudential standards. Given that Basel III is the global standard, de facto this is a question about Basel III compliance. If not complaint, then these securities are compromised, resulting in low-quality capital. Moreover, the Basel Committee will get grumpy if a regulator uses terms like CET1, AT1, or Tier 2 for capital that does not meet the tough Basel III requirements for Common Equity Tier 1, Additional Tier 1, or Tier 2 capital respectively. Taking these terms in vain is just misselling.
   Basel III compliance has many other advantages: it makes it easier to issue capital securities world-wide. This is an important consideration because domestic New Zealand investors alone will not be able to fund the vast amount of capital to meet the new RBNZ capital requirements.
   
3. if credit rating agencies, such as Fitch, Moodys, and Standard and Poor’s, accept the securities as equity. If counted as equity, capital securities contribute to a bank’s credit rating.
   
4. if these securities count as equity under the applicable accounting standards. If yes, then it is easier to impose losses on these securities. Equity holders generally accept risk more easily than debt-holders.
   Moreover, Basel III exempts holders of non-equity accounted AT1 capital securities from losing the value of their investment if a bank’s CET1 ratio drops below 5.125% of Risk-Weighted Assets. See this Basel III criterion 11 for Additional Tier 1 capital:

where the pre-specified trigger point, after many months of discussion at the Basel Committee, was set at 5.125% instead of 7% of RWAs.

On tax deductibility: Yes

The tax authorities will likely accept these securities as debt. A memo dated 20 September 2019 by Susan Guthrie confirms that tax considerations drove the decision to allow banks to issue low-cost capital securities. Admittedly, there is a small note in the memo by Charles Lily of 14 November 2019 that mentions RPPS will lose “tax deductibility relative to current AT1 debt instruments.” But, the loss is only relative, not complete. So, on the balance of probabilities, the answer remains “yes.”

On Basel III compliance: Nope

RPPS are not Basel III compliant. I have spoken with lawyers, issuers, (investment) bankers, fixed-income analysts, … the lot. None of them believes that RPPS are Basel III compliant. The main reason is that RPPS securities cannot be written off or converted into common equity at the point of non-viability (PONV).

PONV is an important post-GFC requirement. Before the GFC, banks repaid capital securities to their holders, even though this would weaken a bank’s solvency and liquidity position. With PONV, however, a supervisor can force a bank to convert non-equity bank capital into capital of the highest quality (CET1), even when a bank is not in resolution.

The PONV requirement allows a bank to top-up CET1 capital, which may just help the bank survive a rough patch or stave off bankruptcy. Unfortunately, the RBNZ decided to not rely on PONV rules, thus giving away a valuable tool to stop banks from entering bankruptcy or resolution.

Weirdly enough, the RBNZ knows that RPPS are not Basel III compliant, see this line from page 78 of the Regulatory Impact Assessment:

In a response to an Official Information Act request to me, the RBNZ also rules out using PONV, because it is a poor fit and because PONV is inappropriate in a New Zealand context (?):

On the other hand, the RBNZ is not very transparent about this. Just branding the RPPS as Additional Tier 1 or AT1 capital implies Basel III compliance, which is misleading.

Branded as AT1, international investors will expect PONV. However, in the absence of this internationally accepted conversion and write-off tool, investors are relegated to national bankruptcy rules and Open Bank Resolution (OBR), which will likely lead to confusion and misunderstandings. Few people know how OBR really works. Consequently, expect AT1 investors to start lengthy court cases after a bank fails or enters resolution.

On equity treatment by rating agencies: Unlikely

At least one rating agency does not think the RPPS deserve equity recognition. I have yet to receive full documentation from Fitch, Moodys, and S&P to sort out why. But, the verdict is unsurprising given that RPPS walk like debt and talk like debt. The payments are only dividend in name. In practice they are interest payments. Also, banks intend to repay RPPS to their holders as is common with debt, hence the name: “Redeemable Perpetual Preference Shares”.

On equity for accounting purposes: Yes, but it doesn’t make sense

The RPPS count as equity under accounting standards. Just Google “IAS 32 and hybrid capital equity” and you will find documents that confirm this, e.g. it looks like this KPMG document offers sufficient clarity.

Apparently, the RBNZ structured the RPPS to qualify as equity under accounting rules to avoid Basel III criterion 11: the conversion or write-down trigger once a bank reports a 5.125% CET1 ratio.

However … , blindsided by the problems of trigger requirements, the RBNZ overlooked an important down-side of equity accounting: Equity accounted securities do not qualify for hedge accounting.

The inability to use hedge accounting is not a problem if a bank wants to issue capital securities denominated in its own, domestic, currency. However, given the large amounts involved, New Zealand’s banks will want to issue abroad: in US dollars or Euros. This introduces foreign exchange fluctuations that continuously affect the value of the RPPS. And because of equity accounting, these fluctuations cannot be hedged.

An amount of RPPS capital that changes on a daily basis because of foreign exchange rate volatility will drive supervisors nuts because it will be a moving goal post.

Missing some other marks

In all, with the introduction of RPPS, it looks like the RBNZ failed to meet some important benchmarks that contribute to the loss-absorbing qualities of these capital securities.

Not readily absorbing losses

Neither do the RPPS meet the Reserve Bank’s own objectives. For example, the RBNZ wants capital to readily absorb losses before losses are imposed on creditors and depositors. However, in the Capital Decisions document, the RBNZ admits that there is a risk that investors may be repaid, even when the bank should retain the funding for capital purposes (see paragraph 27).

Not an easy to manage security

The RBNZ also wants the capital framework to be “practical to administer, minimise unnecessary complexity and compliance costs, and take into consideration relationships with foreign-owned banks’ home country regulators.”

Unfortunately, the RPPS appear to fail on all accounts. I have yet to see someone, RBNZ staff and yours truly included, who understands RPPS. Moreover, in the absence of Basel III eligibility, the RPPS will not likely contribute to the consolidated capital of foreign-owned banks.

A complex capital security for sure

Lastly, according to the RBNZ, the capital framework should be transparent to enable effective market discipline.

Again, after having spoken with many experts, I can only conclude that the RPPS securities are not easy to understand.

How much capital is enough: 13.5 percent CET1.

The result of this all is a capital framework with high Common Equity requirements, but not exceptionally high: many international banks sport CET1 ratios well above 13.5 percent (of Risk-Weighted Assets).

Reading between the lines, the Capital Decisions document seems to indicate that 13.5 percent CET1 capital is enough. The Reserve Bank identifies many risks associated with the RPPS, but then mentions that the decision to set the AT1 cap at 2.5 percent is based on the size of Tier 1 requirement as a whole, and consideration of current CET1 levels among banks. In other words, never mind AT1, 13.5 percent CET1 is enough.

As argued above, the decision to allow RPPS to meet the 2.5 percent AT1 requirement does not really look inspired by prudential considerations. The RPPS are low-cost, low-quality capital, very much like old-style, dysfunctional, Basel II Upper Tier 2 capital.

Adrian Orr, der Macher

But, calling RPPS “Tier 1” capital allows the RBNZ to sustain a narrative of Adrian Orr being a “Macher”, someone who gets thing done: “Doubling capital requirements”, “Jacking up capital requirements to 18 percent.”

It is then sad and depressing to see that one member of the New Zealand financial press corps credits the governor for holding firm under fire on increasing banks’ regulatory capital requirements. I’m sorry, but Orr caved in – and that to the tune of at least 3.6 billion dollars.

A way forward

There is a saying in Dutch: “Beter ten halve gekeerd dan ten hele gedwaald.” Translated, it says that it is better to return half way than to fully lose one’s way.

It is not too late to stick to Basel III requirements for Additional Tier 1 capital. With billions of AT1 in issue world-wide, these securities are well understood. It would be relatively easy to fund the expected $9 billion volume of AT1 capital. Sophisticated investors will eagerly absorb them, which has the added benefit of better monitoring than the monitoring done by domestic (retail) investors.

RBNZ’s worries about PONV and triggering are not really persuasive. With a CET1 capital requirement of 13.5%, the idea that RBNZ will have to trigger capital instruments once a bank approaches a CET1 ratio of 5.125% looks far-fetched. Letting go of the fear of triggering would open the way for global issuances unaffected by forex volatility.

With PONV, the RBNZ can force the conversion of AT1 capital securities in going concern. This to stave off full bankruptcy and lengthy court cases.

A true Governor would show leadership and realise the daftness of the December decisions. It’s never too late to embrace quality.