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PERPETUAL BONDS CAN BE INJURIOUS TO YOUR FINANCIAL WELLBEING.

Posted on 03 Dec 2020

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Nishant Batra – Research Head

“RBI asks to fully write down Rs 318.20 crore of Laxmi Villas Bank’s Tier-II bonds”

“Yes Bank AT1 bond write-down: RBI says investors can’t blame regulator after enjoying high returns in good times”

Headlines like these started doing the rounds after the respective incident for write down of AT2 perpetual bonds of Lakshmi Villas Bank and AT1 perpetual bonds of Yes Bank & investors have a lot of questions and confusions regarding the same. In this article, I will try to explain about perpetual bonds and why retail should stay away from these quasi-equity instruments. AVOID PERPETUAL BONDS (I have used Bold, Italic and Underline to highlight, can’t shout on a word document, this image might help).

One-line explanation for bank’s business model can be they take deposit from the savers and lend them to borrowers at slightly higher rate.

Now think of a situation, where the 10% of the borrowers have defaulted, how will the bank pay the all the savers (depositors).

IN this case, either all the depositors have to take the hit of 10% each or 10% of the depositors (by value) will not get anything. In this example, Bank was trying to earn Interest Margin without investing anything. Total risk was borne by the depositors. Regulators will not like this situation.

Now consider the above situation again with slight adjustment.

Bank’s owners put in 20 as capital and now again assume 10% of depositors defaulted. In this case, depositors will not be penalised, they will not have to take any haircut. Owner will take the loss. This is where the concept of Regulatory Capital comes in.

There are different hierarchies of money which bank use for lending, riskiest category among them is equity capital — money put in by the promoters and other shareholders. It is the riskiest category of capital and in returns they get to share the profits/dividends of the bank. Last in the line is the depositor’s money which only get pre-determined interest with no secondary market. And in between equity capital and depositor’s money is AT1 and AT2 bonds. Please note AT1 bonds are riskier than AT2 bonds.

 

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Capital to Risk-weighted Assets Ratio (CRAR)_

The Capital to Risk (Weighted) Assets Ratio (CRAR), is also referred to as the Capital Adequacy Ratio (CAR). It is the ratio of the bank’s capital assets to the risk weighted assets.

CRAR is decided by the bank regulators to prevent banks from taking excess leverage and becoming insolvent in the process.

The Central Bank considers the relevant risk factors and the internal capital adequacy assessments of each bank to ensure that the capital held by a bank is in proportion with the bank’s overall risk profile.

Banks are expected to maintain a minimum 11.5% capital adequacy ratio (CAR)

It will consist of the sum of the following categories:

  1. Tier 1 Capital (9.5%)
  1. Common Equity Tier 1 (8%)
  2. Additional Tier 1 (1.5%)
  1. Tier 2 Capital (2%)

From regulatory capital view point, going-concern capital is the capital which can soak up losses without setting-off bankruptcy of the bank, this is the Tier I Capital.

Gone-concern capital is the capital which can absorb losses only in a situation of liquidation of the bank. This is Tier II Capital.