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The Asset Class: Stephen Naidoo and Lisa McCleod · Strictly Business

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  You're listening to Strictly Business Podcast with Lindsay Williams.
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  There have been substantial changes to the fixed income market structure with the
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  introduction of a new class of unsecured debt instruments
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  known as Financial Loss Absorbing Capacity or FLAC instruments.
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  With me now, Lisa McLeod and Stefan Naidoo,
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  both portfolio managers at 91 in Cape Town.
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  Lisa, if I can start with you, it's very easy.
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  What and why?
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  What are flak instruments.
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  And why issue yet another new type of instrument into the market?
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  Thanks, Lindsay.
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  So, yes, substantial changes to our fixed income market, as you say.
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  So, FLAC is a new class of debt issued by banks.
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  It's, just to explain it, it's contractually senior to Tier 2 and 81
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  debt,
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  but it is subordinated to the existing senior debt.
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  Thank you.
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  In the event of a bank failure, losses will be absorbed according to a hierarchy
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  of claims.
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  So FLAC instruments will then only absorb losses after all the capital has been
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  depleted and equity in 81 and
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  tier 2 holders.
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  But FLAC will absorb losses before the senior debt holders.
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  As to the why, so why issue a new class of debt?
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  And I think really, you know, if you look across the globe, the systemically
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  important banks are often considered
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  just far too big to fail because when they collapse,
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  it typically triggers this widespread disruption in the financial system.
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  And if we look historically, the risk of contagion then often forces these
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  governments to bail out these banks
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  and they use typically taxpayers' money.
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  So it creates a bit of a moral hazard, if you want to call it that.
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  So banks may take excessive risks because they know that they will be rescued.
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  So it's this issue that needs to be addressed and that's when FLAC instruments
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  come in.
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  It's a financial tool or an instrument that ensures systemically important banks
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  have sufficient loss absorbing
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  capacity so that they can continue operating even during financial distress
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  without the government having to
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  step in.
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  It's really a regulatory change that's taken place in many jurisdictions and
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  South Africa is now following suit.
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  But I think maybe just importantly, you know,
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  in terms of the benefits of a financial system that is required to issue FLAC,
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  I think really it enhances the resilience of a financial system and banks as a
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  whole.
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  It allows banks to respond a lot more effectively in a crisis.
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  It improves their balance sheets and I think it does encourage much more
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  responsible risk-taking.
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  And then, of course, importantly, it reduces the need for governments to then
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  you
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  use taxpayer money to bail out these banks in a crisis.
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  And I think what is important to note is that when we changed our regulatory
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  framework,
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  we actually saw that Moody's upgraded their long term deposit ratings of South
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  African banks.
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  So it's a positive change and it enhances financial systems, strengthens the banks
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  and bank balance sheets.
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  So it should be viewed in a positive light.
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  Stefan, if you don't mind, I'll stay with Lisa.
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  Lisa, I have to ask you, how will fixed income funds across the industry be
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  impacted?
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  And of course, 91 as well.
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  Sure.
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  So if we look at total FLAC issuance,
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  it's likely to be around 250 billion across the sort of six large banks.
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  And it's going to be issued over a period of six years.
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  Then if we look at what is the total vanillia senior bonds that's currently an
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  issue, it's of a similar size.
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  Actually, it's slightly smaller than that.
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  So we expect vanilla senior bonds to be completely replaced by FLAC over the next
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  six years.
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  So funds that currently invest in the senior bank bonds, it can be fixed or
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  floating rate notes,
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  will be forced to replace all their senior bond exposure with FLAC or a combination
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  of FLAC and other instruments such as
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  NCD.
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  So it will be quite a big change in the market.
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  And I think one important characteristic of FLAC is that these FLAC instruments
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  have an expected maturity of longer than
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  one year.
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  So traditional Cisco money market funds that have a maximum maturity of up to 13
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  months,
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  those will not be impacted by the industry change.
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  It's rather the enhanced cash funds and the higher risk fixed income funds that
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  will be impacted.
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  Stefan, thanks very much for your patience.
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  How do these FLAC instruments differ to the existing senior debt currently being
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  issued in the market?
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  And also we've got to have a look at the risk as well.
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  Is there a difference in the risk that one is exposed to?
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  Yeah, Lindsay, you know, the difference comes down to two key things,
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  the first being contractual subordination and the second being explicit bail-in
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  language.
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  So FLAC sits just below senior debt in the creditor hierarchy from day one.
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  So it's not a risk that only appears in a stress scenario.
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  It's written into the contract.
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  And unlike tier two and 81, which can be bailed in at the point of non-viability,
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  FLAC can only be bailed in at the point of resolution.
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  which is a more severe outcome where the South African Reserve Bank is essentially
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  initiating the wind-up of a bank.
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  At that point, it's at the SARB's discretion and flak exposure could be
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  converted to equity or written down entirely.
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  We have the pleasure of having some recent history with African Bank.
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  You know, when African Bank was placed into curatorship in 2014,
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  senior creditors took a haircut despite not being contractually loss absorbing.
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  So the SARB split the bank into good bank and bad bank and senior bondholders
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  received less than par.
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  So I think what we can learn from this point in history is that
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  Saab has quite broad powers to allocate losses across the creditor hierarchy and
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  holding senior debt
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  alone did not provide protection against all losses.
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  So all that's happening now is FLAC makes loss absorption explicit rather than
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  implicit,
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  which is quite an important distinction, but perhaps less of a leap from the
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  current senior debt than it first appears.
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  What about pricing?
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  How will these instruments price in the market?
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  Will you as a financial institution be paid for the additional risk and will the
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  risk of your portfolios at 91 change
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  in any way?
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  Well, FLAC has priced about 10 basis points above Vanilla Senior in the market.
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  To put that into context, Tier 2, which is next down in the creditor hierarchy,
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  sits roughly 40 basis points above Vanilla Senior.
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  So FLAC has come in quite tight, much closer to Senior than Tier 2.
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  and inside what most indicative research at the time had expected.
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  And this has really been driven by very strong demand for the asset class and
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  somewhat limited supply.
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  I guess the question investors need to ask themselves is,
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  is 10 basis points enough as a compensation for an instrument that is now
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  contractually loss-absorbing?
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  And again, I think this is important to revert back to that African Bank episode.
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  where senior creditors absorb losses that they didn't expect to.
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  So, flak holders face that same risk, but it's now explicitly written into the
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  terms.
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  The counter-argument to that is that the probability of resolution for the South
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  African banks is generally quite low.
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  Credit losses would need to be 7 to 14 times higher than historic levels to
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  approach the trigger point for a resolution.
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  And I think this is why it's quite important to highlight the need for...
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  for strong fundamental credit research, because it's pivotal to understand that
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  you're still facing the same fundamental
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  risk drivers of these banks, which is what are the capital buffers in place?
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  What is the ability for these banks to organically generate capital that's in
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  earnings and both in size and quality?
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  What is the robustness of the balance sheet?
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  What risk are these banks underwriting?
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  How well have they provided for credit losses?
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  And what are the liquidity measures in place.
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  So, you know, in our view, we are from a portfolio risk perspective.
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  The practical point is that FLAC issuance is expected to cannibalize existing
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  vanilla senior term issuance.
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  And the volume that the major banks need to issue over the next six years exceeds
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  the amount of senior debt maturing
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  over the same period.
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  So banks would get zero capital benefit from issuing vanilla senior and would
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  simply just stop issuing it.
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  And this goes to Lisa's point that, you know, the longer end of the market,
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  FLAC would progressively displace the vanilla senior bonds as a core building
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  block for SAFIX income portfolios.
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  We don't expect a material increase in portfolio risk.
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  The likelihood of a bank defaulting has not changed with the introduction of FLAC.
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  What has changed is on the 10 from the outset,
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  these instruments are now loss absorbing and we've recognized the shift in our
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  internal ratings.
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  notching FLAC down compared to vanilla senior.
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  And practically, this means within our internal risk framework, we have tighter
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  limits for FLAC exposures than vanilla senior.
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  Lisa, can I end with you?
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  From your comments at the beginning of this podcast, it seemed to me that you
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  welcome at 91,
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  the introduction of FLAC.
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  Is that the case?
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  And is it also important because of what Stefan has said about the African Bank
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  example,
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  and also what you said about the international benchmark?
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  So all together, It's a welcome change.
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  Lindsay, yeah, it is a welcome change.
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  I mean, it is a big change, but I think overall it will lead to a much more sort
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  of resilient market.
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  And I think it's a change that's happened globally.
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  You know, if South Africa did not undergo that change, we would sort of stick out in
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  the global environment.
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  So I think it is a welcome change.
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  Maybe, Steph, you can add to that.
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  I think what is nice is there is no more ambiguity.
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  And what the regulator is trying to say is...
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  you know the risk you're signing up for on day one.
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  And this is the risk you can expect should there be a resolution.
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  Lisa, Stefan, thank you very much for your time.
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  Lisa McLeod and Stefan Naidoo are both portfolio managers at 91 in Cape Town.
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  The views and opinions expressed in these podcasts are those of Lindsay Williams and
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  various contributors and do not reflect the policy,
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  position or opinion of any other agency, organisation,
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  employer or company associated with StrictlyBusinessPodcast.com.
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  entity other than the speaker or the author
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  and since we are critically thinking human beings these views are always subject to
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  change, revision,
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  and rethinking at any time.
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  Please do not hold us to them in perpetuity.