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