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China’s biggest banks are preparing to issue hundreds of billions of dollars in loss-absorbing bonds designed to avoid bailouts, but rating agencies nevertheless expect Beijing to support the nascent market in times of crisis.
Crafted in the aftermath of the 2008 financial crisis, global rules for so-called total loss-absorbing capacity (TLAC) require major banks to issue senior debt that can be written off in the event of a failure, helping to avoid the need for the costly government bailouts that swept Europe and the US.
China’s banking sector, the world’s largest by assets, has yet to begin offshore issuance of such debt 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 assessments of TLAC senior debt. Fitch estimates total issuance could approach $866bn across five state-owned banks by 2028, though the requirements could also partly be met by issuing capital bonds.
“We expect a very high probability of state support to prevent default and below-average recoveries,” said Vivian Xue, an analyst at Fitch Ratings, who added it was “unlikely” that the Chinese government would permit banks to default on such bonds.
Moody’s, which also anticipates an “uplift” to ratings, believes that Beijing’s “primary motivation” to bail out its biggest banks would be “concern that a failure to do so would trigger systemic contagion”.
In a report this year, S&P similarly expected China’s globally systemically important banks to “receive pre-emptive support from the government”, adding that it rated TLAC bonds “differently across markets” to reflect its “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 wider questions over the extent to which so-called bail-ins of bank debt will catch on, especially further away from the Basel-based Financial Stability Board that drafted 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 bailing in debt, which was “probably a consequence of the Eurozone crisis” and “public sentiment that banks should never be bailed out again.
“The truth is when you talk about bail-in to Asian banks . . . they don’t really have much interest in it,” he added. “The supervisors, the authorities . . . they didn’t go through the same problems Europe and the US had.”
In Japan, where the three biggest banks are included in 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 . . . would not allow the situation to develop into a scenario where the TLAC bond will be written down or converted,” said Nicholas Zhu, a vice-president and senior credit officer at the rating agency in Beijing, who pointed to a record of pre-emptive support so that distressed institutions could continue to service their debts.
In China, returns on the debt issued so far domestically are low. A four-year TLAC-eligible Agricultural Bank of China bond issued last month is yielding just 2.1 per cent. That compares with 1.8 per cent for a five-year government bond.
Zhu added that, despite expectations of support, there is “still the possibility of being written down or converted” with TLAC senior bonds in China.
Under TLAC rules, banks need to issue so-called senior bonds that rank below depositors in its capital structure. That marks a change from previous practice, whereby such bonds ranked alongside deposits and were therefore harder to bail in.
The rules expand on Basel III requirements that also cover other capital instruments such as tier 2 bonds and additional tier 1 bonds, which have for years been issued by Chinese banks and are designed to take losses earlier than senior debt.
In Europe, the failure of Credit Suisse in 2023 saw €17bn of AT1 bonds bailed in, although Legras pointed out that the bank’s senior TLAC debt was untouched. He added that yields on Chinese capital bonds, which rallied after the incident, are “super tight” and expensive for investors.
Although authorities in China wiped out tier 2 debt in Baoshang Bank in 2020 as part of the first official commercial bank default in decades, other situations have added to investors’ expectations of support even for the riskiest debt instruments. S&P factors in government support for tier 2 debt from China’s biggest banks, which it says makes them “unique” across its global ratings.
Jason Bedford, a Chinese banking analyst previously at UBS and Bridgewater, pointed to difficulties at the Bank of Jinzhou in 2019, when investors lost coupon payments but local government support led to the repayment of an AT1 bond. “Even though they bailed out the bank, it was strangely not deemed necessary to convert the AT1,” he said.
“The requirement is more that you have bail-in-able debt that you are able to actually bail in, but there isn’t some general rule that you should bail in that debt,” added Axiom’s Legras.
Additional reporting by Cheng Leng in Hong Kong