Loss-absorbing bonds of Chinese banks may never be saved, analysts say

China’s biggest banks are preparing to issue hundreds of billions of dollars in loss-absorbing bonds aimed at avoiding a bailout, but ratings agencies still expect Beijing to support the emerging market in times of crisis.

Created after the 2008 financial crisis, global rules for so-called total loss-absorbing capacity (TLAC) require big banks to issue senior debt that can be called off in the event of a failure, helping to avoid the need for costly government bailouts that have swept Europe and US.

China’s banking sector, the world’s largest by assets, has yet to start issuing such debt offshore and lags behind other regions. However, a TLAC-eligible senior bond from ICBC in May, the first of its kind in China, has already sparked scrutiny of the government’s potential role.

All three major international rating agencies plan to include expectations of government support in their ratings of TLAC senior debt. Fitch estimates that total issuance could approach $866 billion at five state-owned banks by 2028, although requirements could also be partially met by issuing capital bonds.

“We expect a very high probability of state support to prevent defaults and below-average recoveries,” said Vivian Xue, an analyst at Fitch Ratings, who added that it was “unlikely” that the Chinese government would allow banks not to accept such obligations.

Moody’s, which also anticipates an “upgrade” in ratings, believes Beijing’s “primary motivation” to bail out its biggest banks would be “concerns that failure to do so would trigger systemic contagion.”

In a report this year, S&P similarly expected China’s systemically important banks to “receive preemptive support from the government,” adding that it rated TLAC bonds “differently to the market” to reflect his “views on government support”.

The distinction reflects the unique regulatory characteristics of China’s vast and heavily state-run banking system. But it also raises broader questions about the extent to which so-called bank debt bailouts will catch on, especially beyond the Basel Financial Stability Board that drew up the rules.

TLAC “has not been applied very consistently in the world globally,” said Jerome Legras, managing partner at Axiom Alternative Investments. Europe was “more prone” to debt bailouts, which was “probably a consequence of the eurozone crisis” and “public sentiment that banks should never be bailed out again.

“The truth is that when you talk about the bail-in to the Asian banks. . . they don’t really have an interest in it,” he added. “The supervisors, the authorities . . . they didn’t go through the same problems that Europe and the US did.”

In Japan, where the three largest banks are among the 29 globally that must issue under TLAC rules, analysts also expect government support for senior bonds. “Moody’s view is that the Japanese government . . . it would not allow the situation to develop into a scenario where the TLAC bond will be downgraded or converted,” said Nicholas Zhu, vice president and chief credit officer at the Beijing-based rating agency, who pointed to a track record of proactive prevention. support so that institutions in difficulty can continue to pay their debts.

In China, the yield on domestically issued debt so far is low. A four-year TLAC-eligible bond the Agricultural Bank of China issued last month yields just 2.1 percent. This compares with 1.8% for a five-year government bond.

Zhu added that despite supportive expectations, there is “still the possibility of cancellation or conversion” of senior TLAC bonds in China.

Under TLAC rules, banks must issue so-called senior bonds that rank below depositors in their capital structure. This marks a change from previous practice, whereby such bonds ranked alongside deposits and were therefore harder to recover.

The rules extend Basel III requirements to cover other capital instruments, such as Tier 2 bonds and additional Tier 1 bonds, which have been issued for years by Chinese banks and are designed to absorb losses earlier than senior debt .

In Europe, Credit Suisse’s 2023 default led to €17bn of AT1 bonds being recovered, although Legras stressed that the bank’s senior TLAC debt was untouched. He added that Chinese equity bond yields, which have risen since the incident, are “super tight” and expensive for investors.

Although Chinese authorities canceled Tier 2 debt at Baoshang Bank in 2020, as part of the first formal obligation of commercial banks in decades, other developments have added to investors’ expectations to support even the riskiest debt instruments. S&P is considering government support for Tier 2 debt from China’s biggest banks, which it says makes them “unique” in its global ratings.

Jason Bedford, a Chinese banking analyst formerly at UBS and Bridgewater, pointed to difficulties at Bank of Jinzhou in 2019, when investors missed coupon payments but local government support led to the repayment of an AT1 bond. “Even though they saved the bank, it was strangely not considered necessary to convert AT1,” he said.

“The requirement is more that you have bailable debt that you can bail out, but there’s no general rule that accounts for that debt,” Axiom’s Legras added.

Additional reporting by Cheng Leng in Hong Kong