Introduction
The recent changes in the regulatory framework governing the capital adequacy requirements for non-banking finance companies (NBFCs), including Housing Finance Companies (HFCs), have resulted in the introduction of several hybrid instruments aimedat strengthening the regulatory capital basefor these financial institutions. Financial institutions have been issuing such instruments sinceFY2008-09 and the volumes have increased significantly over the last five years. These instruments have attributes of both - equity and debt-instruments and are differentiated based on their loss absorption characteristics.
These instruments typically carry higher risk mainly because the issuers could face restrictions on servicing the coupon on these instruments in case their capital adequacy below the levels stipulated by the Reserve Bank of India, National Housing Bank (in case of HFCs) or in case of losses incurred by the issuer.
Type of Instrument
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Characteristics*
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Maturity | Capital Treatment | Seniority | Discretion Regarding Coupon payment | Loss Absorption Capacity | |
Lower Tier II Debt Instruments (Sub-Debt) | Minimum 5 years | A portion of the Lower Tier II Debt forms a part of the Regulatory Capital of the issuer | These bonds are subordinated to other creditors/ senior debt | None | None |
Upper Tier II Instruments | Minimum 15 years | Upper Tier II Capital and Lower Tier II Capital cannot be in excess of the total Tier I Capital | Subordinated to all creditors - excluding Tier I debt | Coupons may be deferred and are cumulative | Principal may be written down in case of shortfall in regulatory capital |
Tier I Bonds (Perpetual Debt) |
Perpetual | Part of the Tier I Capital upto a maximum of 15% of the total Tier I Capital. Excess quantum shall be included as a part of the Tier II Capital | Subordinated to all other creditors | Coupons are deferred if the regulatory capital falls below the statutory requirement; or in case payment of the coupon results in the regulatory capital falling below the statutory requirement | In case of accumulation of losses/shortfall in regulatory capital requirements, principal amount may be written down |
Rating Framework
Acuité's evaluation of hybrid instruments is a three step process:
The rating so arrived at based on step 1 and step 2will be the upper cap for the rated hybrid instrument.Acuité believes that any instance of default on the senior debt or the Lower Tier-II debt shall inevitably lead to default on the issuer's hybrid instruments. Acuité may equate the rating of the subordinated debt instrument with that of the conventional debt due to the absence of significant loss absorption characteristics in such instruments.
Based on the above factors, Acuité may ratingby upto three notches.
Acuité also notes that in the recent past, the financial sector regulators (RBI and NHB) have allowed issuers to service their interest/coupon commitments on hybrid instruments despite reporting losses - subject to complying with minimum regulatory capital requirements. However, Acuité takes note that in certain unforeseen circumstances, such approvals may be withheld by RBI/NHB and thus the sameconstitutes an important risk factor in the evaluation of hybrid instruments.
Treatment of Preference Shares
Preference shares (Other than those issued to Promoters) shall be treated as debt unless they are compulsorily convertible into equity shares. Acuité shall also be guided by the coupon rate and the residual tenure of the preference shares while deciding the analytical treatment to be accorded. From a legal standpoint, a lender, in distress situation, is in a senior position vis a vis a preference shareholder about claims on the cash flows and the assets. Notwithstanding the legal position , an issuer of preference shares may find it difficult to renege on his commitments to the preference shareholders as such an event will be construed as indicative of deterioration in the credit quality of the issuer , thereby having implications for future fund raising and pricing of debt.
Preference shares issued to Promoters will be treated as equity only if the promoters furnish an undertaking that these shares will be not redeemed till the currency of the bank facilities & any redemption will be refinanced through promoter infusion of an equal amount through equity or equity like instruments
Default Risk Drivers
The default risk arising out of non-payment of coupon/interest on hybrid instruments is linked to the likelihood of the Capital Adequacy Ratio (CAR) of the issuer falling below the regulatory requirement.
Acuité evaluates two risk factors to ascertain the probability of occurrence of any of the above events of default:
Acuité further assesses the available headroom between the current CAR of the issuer vis the regulatory requirement. The historical volatility in CAR enables Acuité to estimate the propensity of the issuer's CAR deteriorating below the regulatory requirement.
Acuité evaluates the expected movement in the internal accretion to the issuer's networth and movement in the risk weights in the issuer's portfolio. An issuer's CAR may experience significant deterioration in case the issuerdecides to take on relatively riskier lending practices or experiences a sudden spike in delinquency levels. Such movements in CAR are affected by the macroeconomic conditions, sectoraland geographic composition of the asset portfolio, collateralisation level, capital structure and interest spreads of the issuer. Acuité relies on expected movements in indicators such as Net Interest Margin and Return on Average Assets to assess the quality of internal accretions to the networth of the issuer over the medium term.
Treatment of Default on Preference Shares
From a default perspective a slippage of a single dividend payment ( even if the issue provides for cumulation of dividends ) or slippage on redemption dates ( whether a regular redemption or an early redemption through exercise of option by the preference shareholder) will be treated as default.