Professor Kevin Davis, a leading academic and member of the Financial Services Inquiry committee, and Michael Saba, a leading fixed income analyst from Evans and Partners have released a paper focusing on the risks of hybrid securities. In it they question whether sophisticated products designed to bolster bank capital were well understood by the retail investors that have bought billions of dollars’ worth of them in the past year alone.
Hybrid securities evolved post the GFC when global bank regulators decided that banks needed to rely more on investors providing critical bank capital rather than taxpayers having to bail the banks out. Hence the design of instruments or securities that convert into bank equity at certain trigger points or, as is the case in Australia, at the discretion of the Australian Prudential Regulation Authority. The hybrids are known as “bail in” securities as opposed to taxpayers having to “bail out” faltering banks.
A leading critic of hybrid securities, AFR columnist and ex-RBA board member Christopher Joye, has long railed against the complexity of these instruments, largely because few investors understand them. Mr Joye recently pointed out that even few institutional investors were aware of the new APRA rules whereby APRA garnishes (or restricts) 40% of all a bank’s earnings once the Common Equity Tier 1 ratio drops below 8% from being used to pay dividends, hybrid income payments or staff bonuses. The trigger was long assumed to be at 5.125%.
Further, the amount of earnings APRA restricts from paying investors, rises the further the CET1 ratio falls (eg, once CET1 drops below 7.125% APRA prevents the bank from using 60% of its earnings for equity or hybrid payments).
These are hard triggers that convert hybrid securities into equity at precisely the wrong time and price for investors – when equity prices are likely to be falling sharply. Added to this are clauses whereby APRA can convert hybrids into equity at its discretion, if it deems the bank is ‘non-viable’. This term has not been defined nor have ASIC chosen to give any guidance as to when it might be used. Even worse, APRA can determine that the hybrid securities will be “written off” completely causing investors to suffer a total loss on their investment.
Hybrid holders are taking the risk that their investment will be used to prop up ailing banks and protect bondholders and depositors allowing APRA to resolve a bank crisis in a more orderly fashion.
Hybrid holders need to ensure that they understand the role they are playing and that they are being adequately compensated for this risk. Importantly, hybrid investors need to understand that hybrid securities are NOT bonds and they are NOT deposits with a bank. The yields proffered look attractive from household name banks but in a globally connected world, a bank run in another market, such as Italy or Spain, could well trigger banking stress in Australia.
Now these scenarios are ‘doomsday’ scenarios most likely if we were to suffer another GFC-style event but Professor Davis believes that a retail investors ability “to assess the likely future outcomes – uncertainty/risk – and determine a fair return is undoubtedly questionable.”
You can read the paper from Professor Davis and Michael Saba.