The Banking Supervision Department has has for the first time permitted a Bank in Israel to raise regulatory capital through bonds
The capital will be raised through a private issue. For the first time, a Bank in Israel has received approval to issue bonds with a loss-absorption mechanism, similar to the practice worldwide.
The capital will be raised through a private issue
v For the first time, a Bank in Israel has received approval to issue bonds with a loss-absorption mechanism, similar to the practice worldwide. Other banks are expected to soon issue additional bonds of this type.
v Bonds with a loss-absorption mechanism (also referred to as contingent convertible bonds) contribute to the strengthening of the stability of the issuing bank and to reducing the support required from the tax paying public should the bank encounter difficulties.
v Investment in this type of bond involves risk from the investor’s point of view, in view of the possibility that losses will be absorbed to the point of writing off the investment under extreme circumstances. Therefore, these bonds by nature are intended for savvy investors with knowledge and experience in evaluating the risks embedded in them, and, as a general rule, are not suited for households.
The Banking Supervision Department has for the first time given approval for a bank in Israel (Bank Mizrahi-Tefahot) to issue bonds with a loss-absorption mechanism, which will be recognized as Tier 2 regulatory capital of the bank. The bonds will be issued through a private issuance for investment bodies.
The loss absorption in the approved bonds shall take place in a case where the bank’s core capital ratio declines below a pre-determined minimum (5 percent), or in a case where the Supervisor of Banks issues such instructions in view of a serious deterioration in the bank’s state and concern over its stability. In such cases, the bonds will be wholly or partially written off. The bank will later be able to act to repay all or part of the debt if its situation improves significantly in the years following the event, according to the terms of the issue.
This approval opens the possibility for other banks to issue bonds of this type that include similar or other loss-absorption mechanisms.
The requirement to add a loss-absorption mechanism to the bonds included in the banks’ regulatory capital (globally referred to as contingent convertibles (COCOs)) is derived from the international standard and is one of the lessons derived from the most recent financial crisis. Bonds of this type act to strengthen the banks’ capital and stability during crises and to materially reduce the fear of default.
In accordance with the international standard, referred to as Basel III, loss absorption in these instruments is done through a forced conversion of the bonds to shares or by writing them off, should the stated conditions reflecting a serious deterioration in the state of the issuing bank exist.
Due to the possibility that investors will absorb material losses under certain conditions, the Banking Supervision Department is acting together with the Israel Securities Authority and the Tel Aviv Stock Exchange to restrict their investment possibility by household and other small investors.
Questions and answers:
What is a security with a loss-absorption mechanism (contingent convertible – COCO)?
A contingent convertible security is a bond, under the conditions of which, should a specific pre-defined event (a trigger event) occur, it undergoes changes that cause the holder of the security to participate in the losses caused to the bank. Participation in losses may occur through the conversion of the bond to shares, at a conversion rate set out in the agreement, or through the total or partial permanent or temporary write-down of the bond’s principal, according to the terms of the agreement.
The risk of loss absorption is reflected in the risk premium on this type of bond, which is higher than for regular bonds. Globally, the risk premium of banks that have issued this type of bond has declined (as noted in the CDS spreads) in parallel with the decline in risk to the banking system in the various countries.
What is the background to issuing contingent convertible securities globally?
The large financial crisis of 2007–9 showed that many leading banks around the world did not have capital of sufficient quality or quantity to absorb the heavy losses they incurred during the crisis. In such a situation, and with no choice, governments were forced to use taxpayers’ money to bail out these banks. As a result, as part of the lessons derived, it was decided to set a new global standard that would significantly strengthen the capital that the banks would be required to hold, both quantitatively and qualitatively. As part of this, it was determined that regulatory capital (as opposed to equity) would henceforth only include securities that are common shares or bonds with a loss-absorption mechanism. The issuance of these bonds was encouraged by regulators in many countries, and the market is growing. Thus, between 2009 and the end of 2014, banks worldwide issued contingent convertible bonds totaling about $210 billion in about 190 offerings.
What loss-absorption mechanisms exist in contingent convertible bonds?
The Basel Committee, which sets the global banking standard, defined two types of loss-absorption mechanisms. The first is a mechanism by which when the defined event occurs, the bond is converted into common shares at the conversion rate set out in the agreement. The second is a principal write-down mechanism, according to which when the event takes place, the liability to the bondholders is written off. This write-down may be in whole or in part, permanent or temporary.
How does a contingent convertible security strengthen the stability of the issuing bank?
When a bank encounters difficulties and the loss-absorption mechanism is activated, some or all of the liability to the bondholders is written off in one way or another. The lowering of liabilities leads to a parallel increase in the bank’s capital. This increase in capital, which takes place in parallel or close to the time at which the deterioration in the bank’s state takes place, may strengthen the bank’s ability to meet its liabilities, and the public’s confidence in this ability.
What is the significance of a trigger for activating the loss-absorption mechanism in which the bank’s core capital adequacy ratio declines to 5 percent?
The minimum core capital ratio that banks are required to hold pursuant to the Banking Supervision directives in Israel is currently around 10 percent for the two largest banks, and 9 percent for the other banks. In practice, the core capital ratios held by the banks are even higher, and reflect an additional capital buffer held against bank risks. A situation in which the core capital ratio of any bank in Israel declines to below 5 percent means that the bank has absorbed very significant losses and that there is concern over its continued existence as a going concern, however its capital remains positive and it remains a going concern.
According to the Banking Supervision Department’s examinations and assessments, a decline of the capital ratio of any bank to the trigger ratio would take place only in a very serious and extreme scenario. It should be noted that this ratio is also lower than the minimum ratio to which the Banking Supervision Department relates when it carries out its annual banking stability stress tests.
The Basel Committee set out a binding quantitative trigger for activation of the loss-absorption mechanism only in relation to the Tier 1 capital instruments, and not in relation to Tier 2 capital instruments (beyond the activation of the mechanism at the Banking Supervision Department’s discretion in a situation where the bank become nonviable). In Israel, the Banking Supervision Department also set a quantitative trigger for Tier 2 capital instruments in order to minimize uncertainty and to increase transparency for investors in this type of security.
In terms of the binding quantitative trigger for Tier 1 capital instruments, it should be noted that in Israel, it has been set at a core capital ratio of 7 percent.