Asian banks and AT1s amid continuing volatility

Investor concern over the banking sector has centered on recent developments in the United States and Europe.

In the United States, Silicon Valley Bank and Signature Bank went into federal receivership in mid-March. First Republic Bank initially received deposits from larger peers after fears of contagion grew; however, J.P. Morgan ultimately purchased most of the bank’s assets in early May after it entered receivership.

These bank failures in the United States were a unique combination of macroeconomic and idiosyncratic factors: A rapidly rising interest-rate environment put pressure on banks, particularly smaller ones, which had significant unhedged long duration investments.

At the same time, the rapid withdrawal of deposits from banks with concentrated deposit bases to capture higher-yielding investments (such as money market funds) meant that liquidity concerns ultimately transformed into solvency issues for a few select financial institutions.

Europe: AT1 write-off triggers global tremors

In Europe, the dynamics were less systemic in nature and more contained. In Switzerland, UBS acquired Credit Suisse in mid-March when concerns about the latter’s solvency, which weren’t new, reemerged.

As part of a government-brokered acquisition, FINMA, the Swiss financial regulator, ordered Credit Suisse to write down the company’s AT1s (additional tier-1 instruments)¹ to zero. In contrast, the bank’s equity holders retained the value of their shares, a controversial arrangement as most investors had expected a seniority hierarchy that would prioritize hybrid bank capital instruments above shares.

While the possible write-down of AT1s has always existed—indeed, it had occurred for other banks, such as Spain’s Banco Popular in 2017—the lack of such a public, widely held, and influential precedent in the asset class shook investors’ confidence globally.

Asia: AT1s show resilient performance amid higher volatility

The tremors from the Swiss AT1 write-down were inevitably felt in Asia, although they were arguably more muted.

The total return of AT1s issued in the region initially declined alongside their global counterparts; however, the fall in AT1 prices in Asia was less severe when compared with other markets and eventually retraced to pre-Swiss write-down levels, while global AT1s remained below those levels. Regionally, Chinese banks’ AT1s showed the most resilience among issuers.

Overall, we believe that volatility in the Asia AT1 market may persist in the short term given the uncertainties regarding the depth and the second-order effects of banking stresses in the United States and Europe. Any further intimation of bank distress could send the sector into another period of amplified volatility.

For AT1s, noncall events¹ could also negatively affect market sentiment toward the asset class; we believe the announcement of new issuance activities should help to alleviate investors’ concerns. Over the short term, we believe there could still be opportunities for strong Asian banks' AT1s where price recovery lags their peers after recent market action.

Although Asia was inevitably affected by recent ructions in the sector, we believe the factors underlying recent instability are less prevalent in the region. Indeed, taking a longer-term view, Asia’s banks are potentially better positioned to navigate volatility relative to their Western peers, providing selective investment opportunities in AT1s.

Asian banks: differentiated ownership and operating models

Although Asia’s banks encompass diverse economies amid varying development levels, the region generally boasts a higher level of state ownership in banks than the United States and Europe.

Assets owned by state-owned institutions, or government sponsored, in Asia’s larger economies are greater than their global peers. The level of state ownership coupled with potential policy support helps bolster the overall stability of the sector in Asia, including proactive policies to mitigate contagion risks.

The operating models of the region’s banks also differ from those in the United States and Europe. Asian banks generally have more conservative liquidity management, which is built on a significant base of household deposits and healthy liquidity ratios. In addition, major Asian economies have introduced some level of deposit insurance, which should protect the vast majority of depositors and potentially mitigate large-scale withdrawals.

Further, Asia’s banks may be more protected from sizable losses related to fixed-income investments. Banks in the region generally hold a lower proportion of fixed income to loans as assets on their books than their Western counterparts. Additionally, most Asian banks’ unrealized losses from available-for-sale assets are accounted for in the core tier- 1 capital ratio as recommended by the International Financial Reporting Standards, which provides a higher level of transparency in regard to genuine capital strength.

The region has also pursued a more gradual interest-rate hiking strategy. Indeed, Mainland China has broadly adopted a countercyclical monetary policy while central banks in India, Indonesia, Singapore, and South Korea have all effectively paused their rate hiking cycles, awaiting further signs of persistent inflation.

AT1s: regional issuance in focus

In our view, the differences in policy support and bank management may offer opportunities among stronger banks in the region’s burgeoning AT1 market.

Although European banks account for a vast majority of global AT1 issuance, Asian banks have been actively issuing the instruments to meet their U.S. dollar funding needs and Basel III capital requirements. Data shows that issuers in Hong Kong and Mainland China accounted for roughly 75% of the region’s outstanding AT1 instruments by market value.

Mainland Chinese banks likely represent a majority of regional (ex-Japan) issuance as they issue these instruments onshore (in the domestic market) as well as offshore in Hong Kong (along with global and local banks). Indeed, in terms of total AT1 issues globally, Chinese state-owned banks have been the top issuers, issuing US$42 billion’s worth of AT1s over the past 18 months.

Source: J.P. Morgan Asia Credit Index junior subordinated bonds market value, as of March 31, 2023.

Chinese banks: strong structural and cyclical support

For several reasons, we believe that Chinese banks may be potentially more shielded from the current global volatility than their peers.

First, state-owned banks, the largest domestic issuers of AT1s, can potentially benefit from policy support due to their status. Mainland China’s Big Four state-owned banks have been classified as global systemically important banks by the People’s Bank of China (PBoC) and the Financial Stability Board. They also play a pivotal role in the country’s economic development and credit allocation. As a result, they’re likely to receive some level of government financial support, particularly during times of increased market volatility or economic turmoil.

They’ve also shown improved operational performance over time. Notably, the problem loan ratio, which is the sum of the special-mention loan ratio and nonperforming loan ratio, has declined over the past five years. At the same time, their tier-1 leverage ratio (tier-1 capital as a percentage on and off the balance sheet) is trending at a historically high level.

Finally, Chinese banks will likely benefit from cyclical policy support amid the current volatility. Mainland China has adopted a countercyclical monetary policy due to its belated economic reopening from COVID-19, evidenced by the recent cut in the banks’ reserve requirement ratio in March.

Overall, the PBoC is expected to pursue a more accommodative path due to lower inflation and the continuing challenges of stoking domestic demand and reviving the country’s property sector over the near term.

Source: China Banking Regulatory Commission, CEIC data, Manulife Investment Management analysis, as of March 31, 2023. T1 refers to tier one. SML refers to second mortgage loans. NPL refers to nonperforming loans. LHS refers to left-hand side. RHS refers to right-hand side.

Credit selection remains critical for Asian banks and AT1s

The recent volatility in the banking sector has reminded investors of the critical importance of robust credit research and selection. Although some Asian banks could potentially benefit from government support, this may not extend to all subordinated instruments. This is particularly true for AT1s designed to bail in investors and protect taxpayers and depositors.

Indeed, two precedents exist in Asia: In 2019, a bank in China was offered government support, but AT1 investors didn’t receive their promised coupon payments. In 2020, the AT1s of Yes Bank in India were fully written down at the directive of the Indian government.

In addition to bail-in risk, AT1 investors also face noncall risk, where bank issuers may choose not to redeem AT1 instruments when they become redeemable, effectively lengthening the tenor of the instruments, potentially into perpetuity. A noncall event could cause a price drop of AT1s in addition to other risks investors are taking.

Overall, we view banks' profitability as a critical factor for investors in their assessment of the credit quality of AT1s. These instruments typically behave like equities during economic downturns because of their perpetual and discretionary coupon skip features; in other words, banks may skip AT1 coupon payments, or their call dates, when they experience net losses.

The general AT1 market may also experience greater volatility when there are increasing risks of a coupon-skip or noncall event. In a more adverse scenario, net losses may trigger a confidence crisis, or even a bank run, which could quickly erode bank capital or liquidity buffers and lead to higher risks of AT1s being completely written off.

Conclusion

Volatility in the global banking sector is likely to continue over the short term as high interest rates and slowing economic growth dominate the macroeconomic landscape. Over the medium term, Asia’s banks are generally better positioned due to stronger government support and more stable fundamental profiles, such as Singapore’s major banks. We see selective opportunities available for AT1s issued by banks with more stable deposit bases, improving profitability, and those whose price have yet to recover fully relative to their peers after recent market volatility.

Appendix: AT1 instruments

AT1s emerged after the 2007/2008 global financial crisis (GFC) as a hybrid security meant to bolster banks’ capital reserves. The motivation was to expose investors in banks to losses, rather than governments and taxpayers who bailed out banks in the GFC, through a bail in or potential loss of capital.

AT1s have become popular instruments to help banks meet capital requirements under the Basel III agreement. They’re counted as part of a bank’s additional tier-1 capital.

1 Noncall risk exists when issuers do not redeem a bond at its call date, such as Banco Santander’s noncall decision that upended markets in 2019.