Types of bank debt: banks do not live on deposits alone

Banks’ activity in capital markets is taking on an ever-greater importance. On the one hand, customer deposits don´t tend to be sufficient to allow banks to carry out their fundamental business:  financing third parties. This obliges them to seek other types of resources. Also, the new regulatory framework requires that any bank bailout should be supported, in the first place, by the shareholders and secondly, by the bank´s private creditors. In order for this new philosophy to be effective, the banks should at all time have sufficient liabilities, with the capacity to absorb losses.

Keeping all this in mind, the activity of financial institutions in the capital markets can be divided into five large groups:

1. Securitizations. A securitization consists of transforming a series of financial assets into bonds, obligations or similar instruments, the majority of which can be traded on the market. The traditional securitization mechanism consists of transferring a portfolio of assets to a vehicle without patrimony that will issue bonds guaranteed by that portfolio. Normally, several tranches of securities are launched in each securitization, with different levels of risk to satisfy the demands of different types of investors and minimize the issue costs. Some of the objectives of the financial institutions that decide to securitize are to capture liquidity, manage their balance sheet and reduce their needs for regulatory capital, which will allow them to provide additional credit. The latter is the normal objective of financial institutions, since it allows them to remove from their balance sheet assets at risk, which would require high levels of capital.
2. Senior secured debt: These have an additional guarantee or collateral which normally is a loan. The most common type are covered bonds (cédulas, or certificates, if they are issued under Spanish law), fixed income securities that are comprehensively supported by the portfolio of mortgage loans (mortgage certificates) or public sector loans (territorial certificates) of the issuer. They have a double guarantee, that of the issuer and the preferential right to the portfolio, over the other creditors. They tend to be medium-term issues (as opposed to deposits, which come due in the short term). By issuing certificates, banks can have a more balanced structure in their balance sheets, as they are able to finance part of their portfolio in the long term (mortgages) with liabilities that have longer maturities than deposits, for example.
3. Unsecured Senior debt: unsecured issues, with a fixed maturity, and without the capacity to absorb losses. Within this category of issues with no additional guarantee are those that have the first collection rights in the event of bankruptcy.
4. Senior non-preferred debt will be eligible as capital under TLAC/MREL regulation. For this purpose, it must meet a series of requirements: have an initial maturity of at least one year, have no derivative features and its investors must assume losses before those of traditional senior issues in the event of resolution of the entity.
5. Subordinated debt refers to fixed income securities that offer a greater return than other debt assets. On the other hand, they lose collection capacity in the case of the bankruptcy and subsequent liquidation of the company, since their payment is subordinated to the order of priority, with respect to senior creditors.
6. Contingent convertible bonds, also known as CoCo or Additional Tier 1 Capital (AT 1 in English). A hybrid issue, with the characteristics of debt (it pays interest to the investor) and capital (it has the capacity to absorb losses). These are perpetual instruments (without a set maturity), although the issuer reserves the right to call the bond, once five years have passed from the date of issue. The coupon payment on this type of bond can be cancelled at the issuer´s initiative (without it being accumulable). The principle characteristic of this type of bond is that, if certain conditions included in the issue prospectus are met, they can be converted into shares. Among the most common of these conditions is that the CET1 ratio (Common Equity Tier 1) falls below a determined value. For this reason, these issues are directed only to institutional investors. Compliance with a series of requirements allows the AT1 issues to be calculated as Additional Tier 1 Capital, according to the existing norms (CRD IV). This regulation allows banks to add 1.5% of additional capital to the requirements, through these issues.