New bail-in bonds ‘pose risks to banks and investors’

7 Oct 2015
Professor Robert Faff

‘Bail-in’ bonds – a new type of funding requirement designed to provide emergency reserves to shore up failing banks – could have the opposite effect and speed up their demise, according to a UQ Business School finance expert.

Professor Robert Faff is also concerned that people investing in such bonds are not being made fully aware of the risks. Professor Faff is a member of the advisory body, the Australia and New Zealand Shadow Financial Regulatory Committee (ANZSFRC), which warned in a recent statement that the bonds were ‘not a panacea’ for struggling banks.

Bail-in bonds, which are already being issued by a number of banks in Australia and New Zealand, have emerged in the wake of the GFC in an attempt to prevent future banking collapses or government bank bail-outs. Their use was approved in principle by the G20 summit in Brisbane earlier this year.

The next G20 summit in November is expected to set new rules requiring banks to create an additional tier of reserves over and above the capital reserves they are required to hold under the Basel Accords. These new reserves can be created using bail-in bonds.

The bonds will pay a return to make them attractive to investors. However in the event that the bank sustains major losses and an agreed trigger point is reached – for example, capital reserves fall below a certain level - they convert to equity. In other words, such investors change status from a seemingly safe position, as a ‘bond’ investor, to one of increased risk, as an equity investor. This change in investor status is a real concern given the negative circumstances in which the conversion is precipitated.

Professor Faff said that while the ANZSFRC agreed that bail-in securities might discourage bank managers from taking excessive risks for fear of hitting the trigger point, it felt that their use could prove counterproductive.

“If a bank hits the trigger or even gets close, it will send a clear signal to the market that its future is at risk, which could be a deadly blow to its reputation and customer confidence,” he explained. “Ironically a system which is designed to give the bank a lifeline could result in its demise.

“What is important is more effective intervention before the trigger is reached to ensure banks are adequately capitalised. We are not convinced there are any advantages from requiring banks to issue bail-in securities rather than simply issuing more ordinary shares.”

Professor Faff said he was also concerned that ordinary investors buying such bonds did not fully understand the risks. The UK has placed a temporary ban on the sale of bail-in bonds to the general public.

“Bail-in bonds are deceptively complex securities yet they are being marketed as retail investments, similar to high-yield bonds,” he added. “While we don’t believe it’s necessary to ban sales to the general public, the information currently being given to investors is inadequate. Unless we see greater disclosure on the part of banks, the regulators may need to step in.”