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Outsiders in

23 January 2013 By John Foley

When China’s banks make a mess, the government usually pays the clean-up bill. But Industrial and Commercial Bank of China’s plan to issue $9.6 billion of so-called “bail-in bonds” suggests the costs of the next crisis will be spread more widely. For investors, there’s room for confusion and conflict.

China’s biggest lender looks set to be the first mainland bank to issue securities that meet new Basel III requirements. The big difference with older bonds is a “non-viability” clause, which means that if the regulator decides the bank is in deep trouble, the bonds can be written down. That has the same effect on a bank’s capital ratios as raising new equity.

Bail-in bonds could be big in China. The country’s top five banks have 15 percent of their capital in subordinated debt, which is being gradually phased out from capital calculations. If the banks merely replace what’s already outstanding with bail-in debt, they would issue bonds worth $96 billion. Private banks and funds are likely to be enthusiastic buyers.

Pricing is likely to be keen too. Other Basel III-compliant bonds have tended to trade with yields 1.5 to 2 percentage points above similar bonds without a bail-in clause. For mainland lenders, traders expect a narrower spread – say 25 basis points – to reflect Chinese banks’ strong capital ratios, and Asian investors’ aggressive search for yield.

But investors are in danger of ignoring two risks. First, Chinese capital ratios may not be as healthy as they look, if bad debts aren’t being properly recognised. Second, Basel gives regulators discretion about when to impose losses on bondholders. Even the decision that a bank needs an injection of public funds can be a trigger. In China, where the banking system is majority owned by the state, that could describe almost any kind of equity issue.

By their nature, bail-in bonds create a potential conflict between shareholders, who don’t want to be diluted by an equity issue, and bondholders, who don’t want to be wiped out. In China, that conflict is intensified because the regulator and majority shareholder are both part of the state. If outside investors aren’t careful, China’s bail-in bonds could leave the cost of the next clean-up squarely on their shoulders.


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