On
September 18, 2014, Standard & Poor’s has published a new
methodology for evaluating banks’ hybrid capital instruments
(“hybrids” in short).
What
are hybrids?
Before
we go into detail, we have to understand what hybrid capital is. It
is something between debt (“I will always pay you back.”) and
equity (“I will pay you a dividend if I make a profit and decide to
distribute it to my shareholders.”).
Examples
of hybrids include preferred stock, deferrable and certain
non-deferrable subordinated debt, trust preferred securities, and
mandatory convertible securities.
What
is the purpose of S&P’s new methodology?
The
rating agency pursues a double purpose: It classifies a bank’s
hybrids to assign a proper issue rating to the hybrids and to build a
proper issuer rating of the bank. In the context of the methodology,
the term “bank” refers to deposit-taking institutions, finance
companies, bank non-operating holding companies, and securities
firms.
How
does S&P classify bank’s hybrids?
Before
we come to the classification, we need to understand S&P’s
concept of adjusted common equity (“ACE”). To make it simple, ACE
determines how much equity a bank needs to compensate for losses in
stress situations. The term “adjusted” is a polite indication
that S&P counts hybrids as if they were equity, although they are
not.
The
concept of ACE then leads us right away to the notion of “equity
content”. Equity content describes the extent to which a bank’s
hybrids can function as equity. Features such as non-payment,
deferral of coupons, write-down of principal, and conversion into
common equity enhance the equity content of a financial instrument.
Hybrids
can have high, intermediate, and minimal equity content. In the first
case, up to 50 % of ACE can be made up of hybrids. In the second
case, up to 33 % of ACE can consist of hybrids. In addition, you can
only cumulate hybrids of high and intermediate equity content if,
together, they don’t exceed 50 % of total ACE. Hybrids with minimal
equity content don’t count for the calculation of ACE.
What
does all this tell us?
Frankly,
I don’t like terms such as “hybrid” or “adjusted”. In my
view, from a risk perspective, you issue either equity or debt, full
stop.
It’s
like the question of citizenship: Let’s assume you are Canadian,
someone in your family is Swedish, and you are wondering whether you
can become a Swedish national. It makes a huge difference whether you
already have a Swedish passport in your pocket or whether someone
simply tells you that you fulfill all conditions to become Swedish
and “only” need to follow the naturalization process with the
Swedish administration.
Resource:
Standard
& Poor’s – Bank Hybrid Capital and Nondeferrable Subordinated
Debt Methodology and Assumptions – September 18, 2014
