Asia Prepares for New Bail-in Bonds

A decade removed from the global financial crisis, the world’s most systemically important banks are preparing to meet new rules on total loss-absorbing capacity (TLAC) by 2019. New TLAC-eligible debt securities, popularly known as “bail-in” bonds, have emerged post-2008 as part of efforts to minimize the need for taxpayer bailouts in future banking crises. In Asia, banks in Japan and China will face tailored versions of these requirements based on the unique features of each country’s banking system. Below, we examine the state of TLAC in Asia.

Japanese and Chinese Regulators Get Ready for TLAC

In the wake of the global financial crisis, the Financial Stability Board (FSB) issued TLAC standards for global systemically important banks (G-SIBs) in order to enhance loss absorption in the event of financial stress and simplify the resolution process through a single point of entry.1 As in other jurisdictions, Asian G-SIBs will need to hold total TLAC—which includes common equity and other regulatory capital in addition to special TLAC-eligible debt—equivalent to 18% of total risk-weighted assets or 6.75% of all assets to reflect total leverage (see Table 1) when the requirements fully phase in.

TLAC-eligible debt must also represent a minimum of 33% of all TLAC. Sitting between secured debt and common equity, TLAC-eligible debt instruments, which can vary in structure by jurisdiction and issuing entity, act as a type of contingent convertible bond. The instrument converts into loss-absorbing equity in the event of a certain pre-specified trigger, which could be the breaching of a certain minimum capital threshold or the more subjective declaration of non-viability by a national regulator.

Japan and China are home to Asia’s only G-SIBs, though national regulators around the region may choose to impose TLAC rules on domestic systemically important banks (D-SIBs). In Japan, the TLAC requirement will be applied to the three Japanese G-SIBs, Mitsubishi UFJ Financial Group, Mizuho Financial Group, and Sumitomo Mitsui Financial Group, as well as one D-SIB, Nomura Holdings. The four largest Chinese banks—Industrial & Commercial Bank of China, Bank of China, China Construction Bank and Agricultural Bank of China—are all in the Financial Stability Board’s G-SIB list, and will therefore be subject to the TLAC requirements, though they will likely be given an additional six years to comply given China’s emerging market status and less developed capital markets.2 China’s banking regulators encouraged the issuance of TLAC bonds for the first time in March 2018, but it remains unclear whether other Chinese banks besides the G-SIBs will need to comply with TLAC.

Notably, the Hong Kong Monetary Authority (HKMA), which hosts major operations of many G-SIBs including China’s, has already published its own TLAC rules. The HKMA currently treats Chinese G-SIBs in the same way as non-G-SIBs given their near-term emerging market exemption.

TLAC Debt Requirement will Challenge Deposit-reliant Asian Banks

Japanese and Chinese G-SIBs, which largely rely on deposits to fund their activities, will need to issue more debt instruments than their global peers to comply with the TLAC debt requirement. Banks in the United States and Europe also have to issue new TLAC-eligible bonds to meet the requirement, but they typically already fund themselves with a large share of bonds.

The TLAC requirement for Japanese banks will be effectively reduced by 2.5 percentage points in 2019 (rising to 3.5 percentage points in 2022) due to pre-funding of potential losses by the Deposit Insurance Corporation of Japan (DICJ). This DICJ funding would then be replenished by the banking industry in the event of its use. As of July 2017, Fitch estimated the Japanese megabanks would need to issue as much as US$50 billion in TLAC-eligible securities to meet the 2019 requirement having already issued US$33 billion in fiscal year-ended March 31, 2017.

That is a significant fundraising lift in Japan, but the requirement will be even greater for Chinese banks when the time comes, in part due to their sheer size. According to the FSB’s preliminary rules for emerging markets, Chinese banks will likely have six more years to prepare for TLAC compared to their global peers, but the clock has started ticking. According to Moody’s estimates, China’s four G-SIBs need to issue an extra US$453 billion of bonds in order to meet TLAC buffer requirements by 2025. To put this number in perspective, Chinese commercial banks issued a total of RMB 380 billion (US$59 billion) in bonds on the domestic interbank bond market in 2017. In March 2018, the People’s Bank of China indicated in a statement that banking institutions should start to explore TLAC bonds as an option to supplement capital. Analysts interpreted this move as a positive signal that China is taking concrete steps to prepare for TLAC compliance.

The TLAC funding gap is challenging because China relies heavily on financial institutions to buy senior and regulatory capital, far more than is the case in places like Europe, where banks tend to buy only a small share of each other’s debt and the investor base is more diverse. Currently bank-issued capital instruments are often bought and held by other Chinese banks, while the Basel Committee does not allow G-SIBs to count each other’s TLAC securities towards capital. The still nascent domestic bond markets do not have the capacity to support the massive TLAC issuance that is forthcoming in the next several years. Expected continued development of China’s bond market could create the depth of investors required to supply funding, but it will still be a heavy ask, requiring a step-up by non-bank investors and likely a large share of foreign funding. Chinese banks will therefore need to frequently tap offshore markets in order to close the funding gap, testing global investors’ appetite for Chinese TLAC bonds.

Given the role of TLAC instruments as “bail-in” debt, it is important to understand the political context around so-called “too big to fail” banks in Asia. While all of the Japanese entities covered by TLAC are private, all four large Chinese banks are state-controlled with very high probability of government support should they get into trouble. In both China and Japan, , the notion of “too big to fail” is not as politically sensitive as it is in Europe and the United States, where the global financial crisis was centered and the concept of bail-in bonds was born. Indeed, even for the private Japanese mega banks, global ratings agencies tend to assume a “very high” probability of government support as compared to their peers in Europe and the United States given this political and policy context.3 China also does not face the political pressure to let the market force play a bigger role in the resolution regime of G-SIBs, as it does in other countries.

The challenge for Chinese and Japanese banks may be compounded by the activity of foreign G-SIBs looking to issue TLAC in Asia. With one of the world’s largest and most active bond markets, Japan has already seen several global banks issue TLAC-eligible, yen-denominated Samurai bonds. These include British G-SIBs Barclays and HSBC and France’s BPCE (which was removed from the list of G-SIBs by the FSB at the end of 2017). In China, French bank Credit Agricole has reportedly requested regulatory permission to issue a TLAC-eligible, renminbi-denominated Panda bond.

Conclusion

As the world’s largest banks prepare for new TLAC rules, Asian regulators are tailoring requirements in acknowledgment of the deposit-centric nature of bank financing in the region. With Japanese and Chinese G-SIBs historically less reliant on long-term unsecured debt than their global peers in the United States and Europe, the fundraising challenge will be substantial, particularly in China, given the still-limited development of local bond markets. Compounding the challenge will be the fundraising activity of non-Asian G-SIBs seeking support from Asian capital markets. Thankfully, the region has a decade to prepare for full implementation of TLAC for its existing G-SIBs.

1. According to the FSB: “The TLAC standard defines a minimum requirement for the instruments and liabilities that should be readily available for bail-in within resolution at G-SIBs, but does not limit authorities’ powers under the applicable resolution law to expose other liabilities to loss through bail-in or the application of other resolution tools.”

2. The FSB plans to confirm the conformation dates for emerging market G-SIBs by the end of 2019, after undertaking a review of the technical implementation of the TLAC standards. The FSB can decide to move up the conformation date if the aggregate amount of China’s private sector debt securities or bonds outstanding (as measured using BIS statistics, excluding issuance by policy banks) exceeds 55% of China’s GDP. As of end-2017, the ratio is less than 20% assuming policy banks account for 80% of outstanding financial bonds.

3. See, for example, Moody’s language on the “very high” probability of government support for Japanese banks versus “moderate” probability of government support for German banks.