Understand bank capital structure to help manage risk: Tyndall AM

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Recent events have emphasised the need to understand the capital structure of banks in order to manage risk, warns John Sorrell of Tyndall AM.

Recent events have emphasised the need to understand the capital structure of banks in order to manage risk, warns John Sorrell, head of credit at Tyndall AM.

“Knowing how an investment sits within the capital structure of a bank’s debt can help an investors manage exposure to risk.

“Investors should understand the different levels of debt, particularly when investing in hybrid bank products.”

Mr Sorrell said that banks issue various securities which have different levels of obligation to pay and which provide the holder with different levels of protection.

These levels are:

  • Secured senior (e.g. covered bonds): These have claims on the bank’s assets as well as, usually senior, claims on the bank.
  • Senior debt and deposits: Bank debt and customer deposits classed as the core financing for the bank. These are the highest level of the capital structure, protected against losses by all levels below them.
  • Tier 2 debt: Subordinated debt, designed to absorb losses if Tier 1 is not sufficient. This often has a fixed payment and maturity schedule.
  • Tier 1 securities: Equity-like securities including common equity and hybrid debt, typically perpetual but may have call options. Expected to absorb first losses if the bank experiences any fundamental problems.

“Within each class, some securities may have seniority over others.  Moreover, for international investors, jurisdictional differences mean that the treatment of the different classes may vary both from regulatory and repayment aspects.”

Mr Sorrell said the downfall of a Dutch mortgage bank at the beginning of the year illustrates the point.

“We believe it has important implications for the Australian bank debt market, particularly the retail market.”

On 1 February 2013, the Dutch government announced that it was nationalising SNS, the fourth-largest bank in The Netherlands. The government also announced a technical legal action referred to as ‘the expropriation of SNS subordinated debt’, which effectively removes all value from the subordinated debt with no expectation of repayment of principal or interest.

Mr Sorrell said SNS had actually issued subordinated debt denominated in Australian dollars, which was due to mature in 2015 but SNS called it in 2010.

“If it hadn’t, Australian holders would now be faced with a complete write-off of their investment.

“The SNS subordinated debt story highlights how being invested lower down in the capital structure can result in a fundamentally different outcome compared with senior debt holders when problems arise.

“Investors should be aware of the extra risks and decide whether the higher return on subordinated debt adequately compensates for taking these risks.

“In the Australian direct investment retail market, it is difficult or impossible to access the senior debt market securities of most issuers.

“This has led to greater investment in banking and corporate hybrid markets, but investors need to be aware of the risks also associated with these investments,” Mr Sorrell said.

Tyndall AM is a multi-specialist Australian investment manager, offering investment funds in Australian shares, Australian and international fixed interest, and alternative assets, as well as a multi-manager capability to retail and institutional investors in Australia.  It has approximately A$23 billion in funds under management (as at 31 December 2012).

Tyndall AM is a wholly owned subsidiary of Nikko Asset Management Co., Ltd., one of the largest asset manager headquartered in Asia with approximately A$149 billion in funds under management (as at 31 December 2012).

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For more information please contact:

John Sorrell – Phone: 02 8072 6357

14 March 2013