The new Russian Basel III framework introduced last year added loss absorbency features linked to two triggers. The first trigger is a breach of a 2% capital adequacy ratio, otherwise known as the common equity tier one ratio. The second trigger is hit if the Deposit Insurance Agency becomes involved with bankruptcy prevention measures at the bank. But EM investors last year stamped their feet and said the definition of the second trigger was too loose — arguing that they were not comfortable leaving the possibility of a writedown on their debt at the whim of the Central Bank of Russia.
Late last year the language was clarified. Under an amended law of November 2013, the Deposit Insurance Agency trigger was defined as the DIA taking a controlling stake of the bank directly or indirectly through a third party. It is a very investor-friendly approach, certainly much more friendly than the comparable language for European subordinated debt that leaves it mostly at the regulators’ discretion with regards to when the point of non-viability has been reached.
But it is important to consider why the European regulators have been so reluctant to make it more investor friendly. xxx It is because they want to be able to deem a bank non-viable on a discretionary basis, and be able to bail in sub debt without being bound by contractual obligations. Investors don’t like the lack of definition, but they like yield. In return, the banks — and importantly, the regulators — get to use subordinated debt like it should be used; they have the option of a bail-in.
The Russian language, on the other hand, is laughably nice to investors. By the time the 2% capital adequacy ratio limit is hit or the Deposit Insurance Agency takes a controlling stake, the bank will be well past the point of non-viability. It is not likely to be in a state where a bail-in will fix things.
Without the functionality of being able to use subordinated debt for a bail-in at an earlier point, what the Russian regulator has done is created a form of debt that falls somewhere between subordinated and senior. Yes, the subordinated debt would get wiped out before the senior if a bank is declared bankrupt, but banks are in general not asset-rich, so chances are that the senior would get taken out with it. There is still a senior to subordinated differential, but one could therefore argue that it should be much smaller — investors should not be rewarded with a chunky yield if they are not taking the risk that goes alongside it.
EM investors are understandably jittery after the financial crisis and after a varied history of dubious treatment in the case of bankruptcy over an even longer period. But the CBR and the Russian government in particular built themselves a good track record in the crisis years of 2008 and 2009 of having treated investors in its banks well.
Investors were buying the subordinated debt in its previous form. Some issuers probably needed to pay a little more for it, but it was getting sold. This is a rare instance where the CBR should have stamped its own feet. They should have refused to limit the usefulness of subordinated debt and waited for EM investors to do what they always do — brush off their fears in return for yield.