Off with his head! Imperious authority drips from every syllable of that command, beloved by the Queen of Hearts in Alice in Wonderland. Suppose the Queen wished to take a lesson in democratic-era propriety in phrasing such exercise of lethal power, she couldn’t do better than to look at the operative part of a letter dated March 11, 2021, signed by an under-secretary to the Government of India in the Department of Financial Services, to the chairman of the Securities and Exchange Board of India (Sebi): “it is requested that the revised valuation norms to treat all Perpetual Bonds as 100 year tenor be withdrawn”.
A command would become a request: you are requested to take your head off, if it is addressed to the offender. Or, in case it is directed at a typical member of the Indian Police Service, whose obedience to political authority trumps any fealty to the Constitution or citizen liberty, you are requested to relieve him of his burden causing cervical spondylosis.
The Department of Financial Services was entirely right to worry about the implications of Sebi’s directive on how to value bonds issued by banks to fill their additional tier 1 capital reserve. But should it have given a public dressing down to the securities market regulator? Or should the finance secretary or the minister got on the phone to Sebi chairman Ajay Tyagi and apprised him of the ministry’s concern? If informal manoeuvres failed to work, there is always the option to convene an emergency meeting of the Financial Stability and Development Council to hold a formal decision to revise the valuation.
The ministry’s public interference in the working of the markets regulator erodes its institutional credibility in the eyes of market players. It is an open invitation to anyone with a problem with a regulatory policy to lobby the Central government, instead of raising the concern directly with the regulator.
There are two separate issues at stake. One is the abrupt change in the valuation of a perpetual bond and its implications for the viability of such bonds. The other is the independence and authority of the regulator. The ministry is entirely right on the first, and entirely wrong on the second.
All bonds are not born equal. Some come with special characteristics. One such characteristic is loss of its value in circumstances specified beforehand. Take catastrophe bonds, which are not yet popular in India, but deserve to be. The bonds are issued by insurance companies, while insuring against natural disasters, say hurricanes or earthquakes. If the event being insured against does take place over the life of the bond (tenor, in bond jargon), the bond would abate, that is, write off the principal, lose its value in whole or part, and the bond holder would suffer a loss.
Why should any sane person buy such a bond when it is issued by the insurance company? Because it would come with a higher coupon, the absolute amount offered at the end of each period, normally a year, as compared to what is available on the normal bond. This risk premium in the interest available on the catastrophe bond makes it attractive to an investor, who bets that the event insured against is not likely to happen in a hurry. Of course, no one would invest only in such high-risk instruments. It is a stand-alone asset class, uncorrelated with business cycles or macroeconomic management and have their attraction, where a slice of a diversified investment portfolio can be parked to get high returns even as other parts of the portfolio are invested in other kinds of asset classes.
After the Great Financial Crisis of 2007-09, capital adequacy norms for banks were tightened, in accordance with the recommendations of the Basel Committee on Banking Supervision, headquartered at the Bank for International Settlements, Basel, Switzerland. Apart from asking banks to hold a higher level of equity capital as a proportion of their risk-weighted assets, the Committee also prescribed additional, loss-absorbing buffers. This is raised as Additional Tiers of capital, by issuing bonds that offer a premium over prevailing rates of interest but are liable to be bailed in, somewhat like equity, to offset extraordinary losses.
In 2013, two banks in Cyprus had to treat deposits above a threshold as equity, that is, the deposits were bailed in, and those who held those deposits with these banks lost their money. If such bail-in of deposits had not happened, all depositors in all Cypriot banks could have lost their money in a generalized banking crisis. External lenders bailed out Cypriot banking after this sacrifice they demanded as a precondition was made. Of course, the depositors who lost their money cried foul, they had not been told that such a fate could overtake their savings. Conveniently, many were believed to be shady Russian businessmen, who were in no position to draw attention to their wealth.
It is to avert such an eventuality that banks build up loss absorbing capital buffers. It is possible to build such buffers entirely out of equity. But that would lock up a lot of capital and reduce the return on banking capital in general. Hence, the alternative of building such buffers with bonds with the special feature that they could skip coupon payments or abate altogether in case of a crisis but offer a higher than normal coupon to compensate for this risk.
These bonds are issued as perpetual bonds, with call options. A perpetual bond does not mature, simply offers periodic interest payments. In the argot of finance, a call option is an option to buy —and a put option is an option to sell — a security at a predetermined price at a predetermined time. If the bond is sold with a call option, the issuer has the option of buying it back.
The pricing of a bond might seem complicated but is actually quite straightforward. What you are entitled to when you buy a bond is a stream of payments over the years: coupon payments at the end of every period (six months or a year, normally) and the maturity value. Suppose the bond is priced at Rs 1,000 at the time of issuance and it matures in 10 years, and offers Rs 100 every year. At the end of 10 years, you will get Rs 1,000 back, in addition to the coupon of Rs 100 for that year. The value today of Rs 100 ten years from now is far less than Rs 100. If you put Rs 46.32 in an account that gives you 8% compound rate of interest, it would grow to Rs 100 at the end of the 10th year. In other words, the worth of Rs 100 ten years now is only Rs 46.32, if you apply a discount rate of 8%. If you apply a discount rate of 10%, Rs 100 ten years from now has a net present value of only Rs 38.55. If the time horizon is longer, with the same discount rate, Rs 100 would be worth even less. Rs 100 available 15 years from now would be worth only Rs 32.54 at a discount rate of 8%.
This is the nub of the problem with the Sebi directive. It says the perpetual bonds issued by banks for their AT1 capital buffer should be valued as if they were 100-year bonds. Right now, they are valued as if their maturity value would be available at the time of the call option, say 10 years from the date of issue. The value of the bond would fall dramatically, if the tenor of the bond is suddenly 100 years, instead of 10. Before the new valuation norm kicks in, mutual funds holding these bonds would dump them. Investors who know their mutual funds hold such bonds would redeem their units before they suffer value erosion. The market for bonds with special characteristics would collapse. Banks would not be able to mobilise AT1 buffers. The government would have to provide additional equity. Hence the government’s intervention, urging Sebi to take back this valuation norm, even as it had no objection to the regulator stipulating caps on how much of their portfolio the mutual funds can allocate to bonds with special characteristics.
Ideally, Sebi should have grandfathered its valuation norms, that is, made them applicable only to new issuances, letting the existing stock of bonds to be valued as they are.
In any case, the government should have avoided giving the impression of taking issue with the regulator. It should have settled the matter without giving the impression of putting pressure on the regulator. Decapitating the regulator or eviscerating its presumed autonomy can leave the body a little incapacitated, and Indian stock markets would lose their sheen.