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Understanding The Hybrid Capital As The Investment Option

This time I will discuss the hybrid banking capital, who should invest in the hybrid capital and what the investor have to understand about the hybrid capital, before committing investments.

First of all, let’s remember that generally we have three investment options, though one of them is not the investment in its general mean. The first is a fixed income investment, which typically have the following basic characteristics: low risk profile; guaranteed and fixed interest payments; guaranteed principal repayment; secured by company’s assets. There are different grades of fixed income investments, but the very nature of such investment is that it has a fixed and periodic income, guaranteed principal repayment on maturity and is secured by company’s assets. The opposite option is an equity investment, which typically have the following basic characteristics: high risk profile; unfixed dividend payments; not guaranteed principal repayment; participation in company’s profits.

The fixed income and equity are two basic investment options and in this case the company’s capital structure has two basic layers: equity and debt. The bedrock is the equity layer, which is accompanied by retained earnings. The key property of the equity layer is its ability to absorb losses. The overlying layer is the fixed income capital or debt, which should be secured by company’s assets and should not excessively burden the underlying layer. These two basic investment options compose the non-speculative capital structure.

The third investment option, which is actually not the investment in its general mean, covers all other financial instruments that have different features and advanced properties attached to them. These are all kinds of convertibles, equity and fixed income derivatives, quasi-equity, etc. Though, with regard to vanilla convertible bonds, they can be considered as both fixed income and speculation instruments. It depends on the investment strategy. You can buy the bond and hold it to maturity without exercising its convertible option, or you can speculate on the price of the underlying asset – the ordinary share price in this case.

With regard to the capital structure, all those stuff forms a mezzanine capital layer between the two basic layers – equity and debt. Basically, if a financial instrument has an option or a feature attached to it which depends on underlying asset or its future behavior, then such instrument can be consider as speculative and must be treated as a part of the mezzanine capital. The more heterogeneous the capital structure, the more speculative it is – thus the more distress-eligible. The preferred shares can be regarded as an individual case. They form the quasi-equity sub-layer of the mezzanine layer and can be considered as a kind of equity boosters, if the convertible feature is attached to them.

We have approached the point when we can understand the hybrid capital as an investment option. I will consider bank’s capital structure using my aforementioned considerations. The understanding is very simple. Any kind of mezzanine or hybrid capital, which has different options, conditions and triggers attached to it and is used to regulate the bank capitalization, should be considered as an investment option only by specialized financial institutions such as bank holding structures and other banks. Investments in the bank’s mezzanine capital should not be considered by any other investors and non-financial companies (see my previous articles, where I rationalize investments in the bank equity).

With this regard, we also have to think about the loss absorption characteristic of the mezzanine capital. Since the main purpose of the hybrid capital is to be used to boost the core capital during tough times, the question is how such write-downs will affect upstream debt holding institutions? How their earning power and own risk-profit profile will be changed in this case? Due to interdependencies, how far along the chain a shock event can propagate and what will be the last resort, where the shock event can be settled? Will financial institutions invest in a kind of regulatory capital, knowing that their quasi-fixed-income investment can be written down or converted into the equity by the regulator, when a shock event hits the bank?

These questions, as well as other considerations, suggest that the hybrid capital is a kind of regulatory capital, thus it must be used only by the dedicated entities and should not be the subject to speculations and should not be considered by inexperienced investors. It should be the restricted area, with the reliable and clear shock event settlement mechanism.