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The global financial crisis shined a spotlight on some of the weaknesses in the financial system and forced some governments to come to the aid of large banks, overburdened with debt. The summary conclusion of this was recognition of the need for a new system of regulation in which banks were far better capitalised than in the past to make sure that governments never again had to bail out the financial sector.
The result was the introduction of a new kind of bank debt that could be converted into equity under conditions of extreme stress. Holders of this new ‘hybrid’ debt could be forced to change sides from being a creditor of the bank to being one of its owners: wiping out the bank’s debt and shoring up its share register at the same time. This new kind of debt is referred to as a Basel III compliant hybrid.
Conversion of the instrument from debt to equity could occur at certain trigger points. These are known as:
- Non-viability triggers
- Common equity capital triggers, when common equity capital ratio falls below a pre-set level
In Australia, the non-viability trigger is determined by APRA although APRA has declined to give any specific advice on what would cause it to pull the trigger, saying only ‘we’ll know when we see it’. A trigger event would relate specifically to the financial strength of the issuing bank.
The financial strength of a bank is determined by its Tier 1 and Tier 2 capital levels. Tier 1 (core) capital essentially includes equity plus convertible preference shares and Tier 2 (supplementary) capital includes hybrid instruments and subordinated term debt.
Figure 1 shows the place of various investment instruments in the credit hierarchy.
Source: ASIC report 365 on Hybrid securities
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