In any restructuring/liquidation event, equityholders should receive no value from the assets until all the creditors have been fully repaid21. Moreover, senior creditors should be paid first before the junior (subordinate) ones. This is the so-called Absolute Priority Rule (APR). The Black-Scholes-Merton analysis of liabilities from the option pricing theory is very useful to illustrate creditors’ stake in the company as a call option holders on the bank’s assets. When the bank defaults on its debt, creditors take over the bank. In other words, senior creditors have the right to claim both principal and interest on the bank’s assets; once they are made full, they receive nothing beyond that. Senior creditors are in fact taking a covered call position on the assets. They are long the bank’s assets and a short a European Call Option with a strike price equal to the outstanding senior debt.
21
Figure 4.26: Global AT1 by Currency; Source: AT1 Handbook; Societe Generale (2016)
Figure 4.28: Banks; AT1 Issuance to Come; Source: AT1 Handbook; Societe Generale (2016)
Figure 4.29: AT1 Returns vs Comparable Assets; Source: AT1 Handbook; Societe Generale (2016)
Subordinate creditors come after senior creditors. Their position can be represented by a bull-spread position on the assets. They are long a European Call Option with a strike price equal to the senior debt and short a European Call Option with a strike price equal to the overall amount of both senior and junior debts.
Finally, equityholders own the residual value of the bank once creditors are repaid. They are effectively long a European Call Option with a strike price equal to the overall amount of both senior and junior debt. These positions are depicted in Figures 4.30 and 4.31.
There is empirical evidence, largely in the US, that APR deviations are common in restructuring proceedings (Chapter 11) and informal workouts. These violations occur because they are privately optimal for all investors as strict observation of the APR can lead to perverse incentives for both equityholders and junior creditors and aggravate the embedded agency costs. In fact, the APR deviations are basically payoffs from creditors to equityholders to make wise investment decisions while thefirm is in distress.
Figure 4.30: Senior and Junior Option; Source: author
of creditors when imposing losses to bondholders. Guiding Principles imply that:
• Equityholders and creditors should not be worse offthan in liquidation under a normal solvency proceeding.
• Bail-in should be conducted in such a way that preserves the pari passu treatment of all creditors and the statutory rank which is envisaged under the insolvency law.
Though Bail-in underlines that supremacy of creditors over equityholders (in the sense that equityholders take the first loss as in any restructuring proceeding), it does not mention anywhere that bondholders should only take the second piece until the equity is fully wiped out. Moreover, since statutory/contractual Bail-in contemplates events where bondholders suffer losses before the equity is depleted highlights the breach of the Absolute Priority Rule that should govern the capital markets . This is the so-called Deviation from the Absolute Priority Rule (DAPR).
Figure 4.31: Shareholders Option; Source: author
Figure 4.32 shows a bank with 100bn assets funded through 10bn of equity, 2bn of subordinate debt with a 100% write-down clause and 28bn of Bail-in able debt. CT1 and T1 ratio are 10% and 12% respectively.
Figure 4.32: Capital Structure
Now the bank incurs a one offloss of 10bn as in Figure 4.33 dragging CT1 below 7% which triggers the write-down mechanism of the subordinate bond. Furthermore, as the
subordinate bond is not large enough to tackle all losses, Bail-in on senior debt kicks22 in and helps absorbing losses.
Assets Liabilities Ex ante Assets 100.0Deposits 30.0 Loss (10.0) Short term senior 30.0 Ex Post Assets 90.0Bail in able senior 21.0 Tier 1 Subordinate 0 Equity 9 Ratios Core Tier 1 10% Tier 1 10%
Figure 4.33: Post Losses Capital Structure
Pre loss CT1 is 10% before the one-off loss. Equityholders take thefirst 3.7bn up to the 7% trigger where subordinate holders take the second loss and are wiped out. As there are still 4.3bn of losses, Bail-in able senior take the third loss. CT1 is still 7% so some Bail-in able senior is converted into equity to restore CT1 to 10%.. Infigure 4.21, one can see the subordinate and senior bondholders take the brunt of losses (100% and 25% respectively) while equityholders only take a 37% loss with a potential full recovery23 should the losses happen to be just an exceptional event or in due course, the bank manages to restore profitability once the loss making exceptional is gone. This is show in both Figure 4.34 and 4.35
22From 2016 onwards, Senior Bail-in will be available (contractually, statutorily or structurally) as a going
concern absorbing tool.
23This is out of the scope of this thesis but one can quickly infer the harsh treatment on bondholders
that lose most of their investment whereas equityholders just suffer some initial losses (and further dilution upon senior bond conversion into equity) but could overcome these losses in the future. Financial shares always trade on a normalized ROE basis (Price to book vs ROE) so if the underlying business of the bank is unaffected after the one-offloss, shares could trade back up to the pre one-offlosses level quickly and shareholders recover their initial loss whereas subordinate bondholders have seen their investment wiped out.
Asse ts Liabilitie s
Ex ante A sse ts 100.0De posits 30.0
Loss (10.0)Sho rt te rm se n io r 30.0
Ex P ost A sse ts 90.0Bail in able se nior 21.0
Tie r 1 Su b o rd in a te 0 Eq u ity 9 Ratios Core Tie r 1 10% Tie r 1 10%
Figure 4.34: Loss and Trigger
Loss Equity 37.0% Subordinate 100.0% Bail in able senior 25.0% Written Down 15.0% Converted into equity 10.0%
Figure 4.35: Recovery Value