Sunday, November 2, 2014
Are you Swedish? – S&P’s new methodology on Bank Hybrid Capital
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.
Standard & Poor’s – Bank Hybrid Capital and Nondeferrable Subordinated Debt Methodology and Assumptions – September 18, 2014