The Long and Short

Reevaluating regional bank capital structures

| May 5, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The recent collapse of Silicon Valley Bank (SIVB), Signature Bank (SBNY) and First Republic (FRC) have generated new questions and confusion about regional bank capital structures and the assignment of losses to different stakeholders in the event of a bank resolution. These high-profile US bank failures mark the first test of rules and procedures set up after the Global Financial Crisis that were designed specifically to mitigate the impact to the broader financial system. The implementation of these safeguards has challenged some long-held notions about debt capital structures for banks, and how different debt classes would be treated during a stressed recapitalization. There has always been some confusion about which debt has seniority at any given banking institution; this is now exacerbated by how the FDIC appears to be assigning recovery value. Investors in smaller regional bank bonds may be better served by moving down the capital structure, in some instances into preferred securities, out of senior and subordinated debt instruments.

Exhibit 1. Traditionally perceived seniority of systemic bank holding company stakeholders post-Dodd Frank

Source: SanCap

The emphasis on bank holding companies in the US as the single point of entry for a bank resolution of a systemic bank has created the framework for debt that qualifies as total loss absorbing capital (TLAC) for those institutions. The idea being that in a recapitalization the FDIC would create a bridge entity and transfer the systemically important parts of the bank to the new entity and then assign losses accordingly. This notion is similar in non-US jurisdictions such as the EU and UK, where “ring-fencing” of traditional bank level assets (and presumably debt) protect them while senior non-secured debt that qualifies as TLAC is earmarked for loss absorption in a recapitalization.

The assumption in the US had become that smaller, non-systemic regional banks with holding company structures would be treated similarly to their systemic counterparts in a recapitalization and that debt losses would likely adhere to similar type of treatment, even though their bond indentures do not contain the same type of language as they do at systemic banks. In short, with regard to loss absorption, the perception had previously been that the lowest priority would remain with common equity holders, then preferred, then junior subordinated, then holding company subordinated debt, followed by senior holding company debt (TLAC eligible). Only after those layers of the capital structure were exhausted would senior bank note holders, and lastly uninsured depositors, be assigned losses. What has always been confusing among investors, as well as the rating agencies, is the seniority between senior holding company debt and subordinated bank level debt – particularly for non-systemic regional banks. Perceptions, ratings, and valuation often became a function of the individual institution’s make-up and the amount of viable assets at the holding company level. For the systemic institutions, Moody’s and S&P typically rate the subordinated bank debt higher, where as Fitch would typically give priority to the senior holding company debt.

SBNY and FRC added to this confusion as neither bank was structured with a holding company, meaning all debt outstanding remained at the bank level. Alternatively, SIVB had a traditional holding company structure, with senior debt issued at that level and commensurate assets available. Because of this factor, recovery value on the SBNY and FRC debt (neither of which was assumed by the banks that bought them – NYCB and JPM, respectively) is trending toward zero. Meanwhile, SIVB, which does have some assets available at the holding company is seeing its holding company debt valued somewhere around $0.60 on the dollar in the secondary market until a final recovery value is assigned. This seems to set a confusing precedent if another regional bank failure were to arise, if that institution were to have debt outstanding at both the bank level and holding company level. In particular, as these cases prove, with the presence of government/regulatory intervention making it even harder to predict the exact outcome for various stakeholders. While not in the US, the Credit Suisse situation, a government-assisted takeover by UBS, demonstrated the unpredictability of these outcomes. In that case, both holding company and bank level debt holders alike were made whole, but the AT1 contingent convertible holders were written down to zero in a controversial move by regulators.

Because of this dilemma, it seems possible that going forward the US regional banks will need to issue holding company and bank level debt with more clearly defined language in their bond indentures with regard to loss absorption. The systemic banks’ holding company debt, which is TLAC eligible, contains fairly standard language that establishes the debt is subject to losses under a stressed recapitalization scenario.

Exhibit 2. Sample loss absorption language from systemic holding company debt

If we enter a resolution proceeding, holders of our debt securities and equity securities would be at risk of absorbing our losses.

If we enter a resolution proceeding under either the U.S. Bankruptcy Code or Title II of the Financial Reform Act, our losses would be imposed first on holders of our equity securities and thereafter on holders of our unsecured debt, including our debt securities, and some or all of such securities could be significantly reduced or eliminated as a result of such resolution proceeding.

Under our SPOE resolution strategy, and the single point of entry strategy preferred by the FDIC under Title II of the Financial Reform Act, the value that would be distributed to holders of our unsecured debt, including our debt securities, may not be sufficient to repay all or part of the principal amount and interest on such debt, and holders of such debt could receive no consideration at all under these resolution scenarios. Either of these resolution strategies could result in holders of our debt securities being in a worse position and suffering greater losses than would have been the case under a different resolution strategy. Although SPOE is our preferred resolution strategy, neither Bank of America nor a bankruptcy court would be obligated to follow our SPOE strategy. Additionally, the FDIC is not obligated to follow its “single point of entry” strategy to resolve Bank of America under Title II of the Financial Reform Act. For more information regarding the financial consequences of any such resolution proceeding, see ‘Description of Debt Securities—Financial Consequences to Unsecured Debtholders of Single Point of Entry Resolution Strategy’ below.”

Source: Bank of America company filings, recent bond prospectus: CUSIP 06051GLH0, BAC 5.2885% 04/25/34 issued on 04/19/23

Until more clarified rules and language are established for regional bank company debt, holders appear subject to the precedent set forth by SIVB, SBNY and FRC. In which case, holders of bank level debt at non-systemic regional bank companies could see recovery values at or near zero while holding company debt is treated more favorably in resolution. In which case, it seems the better course of action would be to move down the capital structure to get better risk compensation (preferred securities) and/or better prospective recovery value (holding company notes) in the event of a stressed recapitalization.

Dan Bruzzo, CFA
1 (646) 776-7749

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