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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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Assumptions made on the analyses are not
reflective of the position of any other

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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.
