Chinese Banks Arm Themselves with Loss-Avoidance Bonds

The largest Chinese banks are preparing to issue hundreds of billions of dollars in so-called loss-avoidance bonds. These bonds are intended to help avoid costly government bailouts, although rating agencies still expect Beijing to intervene in the event of a crisis. The global rules for the so-called Total Loss-Absorbing Capacity (TLAC) were established after the 2008 financial crisis and require large banks to issue senior bonds that can be written down in the event of failure. This is meant to circumvent expensive government bailout measures, as seen in Europe and the USA. Although China's banking sector, the largest in the world by assets, lags behind other regions, ICBC issued the country’s first TLAC-eligible senior bond in May. This issuance has already drawn attention to the potential role of the government. All three major international rating agencies plan to consider government support in their assessments of TLAC bonds. Fitch estimates that the total issuance could amount to around $866 billion by 2028. These requirements could, however, be partially met through the issuance of capital bonds. Vivian Xue, an analyst at Fitch Ratings, expects a very high probability of government support to prevent defaults and below-average returns. Moody's sees Beijing's primary motivation for bailouts as the concern that failing to intervene could trigger systemic contagion. In a report published earlier this year, S&P also expected that China's systemically important banks would receive preemptive support from the government. Jerome Legras of Axiom Alternative Investments noted that TLAC rules are not applied consistently worldwide, with Europe tending to manage debt reduction independently. In Japan, where the three largest banks fall under TLAC rules, analysts also expect government support for senior bonds. Nicholas Zhu of Moody's believes that the Japanese government would not allow a reduction or conversion of TLAC bonds. The current returns on TLAC bonds issued in China are low. A four-year TLAC-eligible bond from Agricultural Bank of China yielded only 2.1% last month compared to 1.8% for a five-year government bond. Despite expectations of government support, Zhu notes that there is still the possibility that TLAC bonds could be written down or converted. TLAC rules require banks to issue senior bonds that rank behind depositors in the capital structure. This marks a shift from previous practices where such bonds ranked equally with deposits. The insolvency of Credit Suisse in 2023 led to the retention of €17 billion in AT1 bonds, although the senior TLAC debts remained untouched. This has resulted in Chinese capital bonds, which saw a significant increase in value after the incident, becoming extremely expensive for investors. Although Chinese authorities wrote down Baoshang Bank's subordinated capital in 2020, marking the first official bank failure in decades, there are still expectations of government support even for the riskiest debt securities. Jason Bedford, an analyst for Chinese banks, referenced difficulties at Bank of Jinzhou in 2019, where investors lost coupon payments, but government intervention led to the repayment of an AT1 bond. The requirement is more about the existence of such bonds being available to be written down if necessary, rather than a general rule enforcing such write-downs, according to Legras.