Global Sector-Specific Rating Criteria Criteria Address Hybrid Equity Credit : This rating criteria report covers how Fitch Ratings treats hybrid securities (or assigns equity credit ) in its analysis of bank or bank holding company capital. Common Equity Most Effective Capital: Fitch s primary measure of bank capitalisation is Fitch Core Capital (FCC), which is based on common equity and excludes all types of hybrid instrument. Fitch believes that common equity is the most effective form of capital for maintaining a bank s viability, given its high loss absorption potential as first loss capital, its full dividend flexibility and its contribution to maintaining (or at least not harming) bank confidence. Feeds Into Ancillary Ratio: Nonetheless, Fitch still sees merit in quantitatively measuring the existence of good-quality hybrid capital in an ancillary ratio. Consequently, the agency calculates Fitch eligible capital (FEC) for banks, complementing regulatory capital and other market measures of bank capitalisation such as tangible common equity. Fitch s FEC adjusts FCC to the extent that a bank s hybrid securities receive equity credit. 100% Equity Credit: 100% equity credit is assigned to: i) short-dated (under three-year), subordinated mandatory convertible securities with full coupon flexibility; and ii) permanent, subordinated securities with full coupon flexibility and the ability to be written off or converted into common equity well before a bank becomes non-viable. 50% Equity Credit: 50% equity credit is assigned to: i) subordinated perpetual instruments with full coupon flexibility; ii) subordinated instruments with at least five years until maturity that can be written off or converted into common equity well before a bank becomes non-viable; and iii) other short-dated (under one-year) mandatory convertible securities. No caps: As FCC is Fitch s principal measure of bank capitalisation, the agency does not restrict the amount of equity credit that can be included in FEC. Related Criteria Global Financial Institutions Rating Criteria (August 2011) Rating Bank Regulatory Capital and Similar Securities (December 2011) Analysts James Longsdon, EMEA +44 20 3530 1076 james.longsdon@fitchratings.com Christopher Wolfe, North America +1 212 908 0771 christopher.wolfe@fitchratings.com Mark Young, APAC +65 6796 7229 mark.young@fitchratings.com Franklin Santarelli, Latin Aamerica +1 212 908 0739 franklin.santarelli@fitchratings.com Replacement Report: This criteria report replaces one of the same name dated 11 July 2011. There have been no substantive changes, and no rating actions will therefore arise due to the publication of this report. By end-2012, Fitch expects to republish this report, merging it with the agency s Rating Bank Regulatory Capital and Similar Securities criteria report. Subsequent changes, if any, are likely to be driven by developments in the industry and/or the legislative and regulatory framework surrounding regulatory capital or bail-in debt. Scope: This report aims to evaluate hybrid instruments invested in by unaffiliated investors who are expected to exercise all remedies available to them. Government subscribers to hybrid securities may not always fit this description, while companies making a capital injection into a subsidiary frequently use hybrid structures to increase the tax efficiency of their investment. In such cases, Fitch rating committees may apply different standards and assign more equity credit to a security than would be achievable in the hands of an unaffiliated investor. Limitations And Key Assumptions: The effectiveness as loss-absorbing instruments of newstyle regulatory capital of the type that may be able to achieve equity credit under these criteria has yet to be tested. Fitch believes contractual features and regulatory desire to impose loss absorption means new-style capital securities will be more effective than their predecessors in absorbing losses in a going-concern scenario. Were events to cause Fitch to doubt their effectiveness, the level of equity credit assigned might reduce or even be eliminated. www.fitchratings.com 9
Process Considerations These criteria on hybrid treatment apply to outstanding hybrid securities and to hybrids issued after this report s publication. Bank hybrid capital is a rapidly evolving asset class. As a result, Fitch s equity credit criteria may be liable to more frequent revision than other criteria. Rating committees retain flexibility in application of these criteria to specific situations not contemplated in this report. What is Equity Credit? Equity credit is an analytical concept that expresses the extent to which Fitch views a security as containing debt-like or equity-like qualities in a risk-adjusted evaluation of an issuer s capital structure and financial leverage. Such risk-adjusted evaluations of capital are used in support of the Viability Rating (VR) that Fitch assigns to the issuer itself. The VR is a measure of the likelihood that an issuer may fail and either default on its obligations or need external support in order to avoid default. Where a bank s Long- and Short-Term Issuer Default Ratings (IDRs) are based on its VR, rather than its Support Rating, equity credit may also affect the level of the IDRs. Capital securities and hybrids are evaluated as to their likely effect on the viability of the issuer and on the issuer s senior obligations under the condition of financial stress, regardless of the probability that such financial distress will occur. Fitch s allocation of part or all of a hybrid instrument to equity is not driven by accounting rules. Financial reporting standards do not determine the agency s analytical assessment, although changes in accounting standards may cause Fitch to alter its adjustments to data derived from financial statements. Common stock and reserves are more supportive of bank viability than any hybrid security. FCC is Fitch s primary measure of bank capitalisation. High-Level Principles Common Equity The Most Effective Form Of Capital The experience of the financial crisis confirmed that hybrids are only effective to the extent that they contribute to the ongoing viability of an organisation, and this is the overarching principle Fitch has employed when determining the extent to which a hybrid security can achieve equity credit. In essence, bank hybrids have the potential to support the issuer s viability if they are able to cancel coupons and/or be written off or converted to common equity (or equivalent first loss capital). This does not automatically mean all securities with such features will receive equity credit. For banks, the extended financial crisis has demonstrated the importance of maintaining confidence and rapid loss absorption in preserving the viability of a banking organisation. Common equity is viewed as the most effective form of capital for maintaining a bank s viability given its high loss absorption potential as first loss capital, its full dividend flexibility and its contribution to maintaining (or at least not harming) confidence. Although hybrids aim to replicate some of the key features of common equity, Fitch views them as less versatile than common stock. The superiority of common equity means that FCC, largely consisting of common equity and reserves, is Fitch s primary measure of capitalisation when assessing a bank s VR in most circumstances (see Fitch Core Capital: The Primary Measure of Bank Capitalisation, published on 19 January 2012). While the ultimate features of new generation bank hybrid securities will no doubt vary globally by jurisdiction, characteristics such as full coupon omission flexibility and write-off or conversion features mean that Fitch believes new-generation hybrid securities will provide greater equity-like benefits for banks than old-generation hybrids. 2
Where hybrid securities are expected to contribute to the preservation of viability and therefore receive equity credit, this will continue to be captured in the FEC ratio. Such instruments should generally enhance first loss capital well before financial stress. The FEC ratio will remain an important measure of bank capitalisation in Fitch s analysis as it will represent a quantitative measure of secondary-quality capital and will differentiate banks with this form of goingconcern insurance from those without it (or those with more of it from those with less of it). No Equity Credit Caps Because FCC is Fitch s principal measure of bank capitalisation, the agency does not restrict the amount of hybrid securities that receive equity credit in its calculation of FEC. Three Equity Credit Buckets Consistent with other Fitch groups, the Financial Institutions group uses only three categories when assigning equity credit: 100%, 50% and 0%. This reflects Fitch s desire to avoid a false degree of precision. Fine nuances in hybrid design have often not materially affected an issuer s ability to maintain viability, and in some cases the additional complexity associated with such features has negatively affected performance. 100% Equity Credit Perpetual Instruments With Coupon Omission Features The following features will be necessary for such securities to achieve 100% equity credit: Subordination: The securities must be subordinated to all senior creditors and in most cases senior only to common equity or, for non-joint stock companies, the most comparable first loss capital. Permanence: The securities must be perpetual, with no step-ups or incentives to redeem. They must have at least five years to the first call date at issue, and supervisory approval is required for any repayment of principal. Full discretion to cancel coupons: This means features such as look-back/dividend pusher clauses and parity securities language are likely to negate a security s ability to obtain equity credit. Permanent and full write-down or conversion to first loss capital (in most instances common equity) well before a bank becomes non-viable: The point at which a bank might be considered non-viable will be determined by a rating committee and is likely to vary by type of bank and by jurisdiction. For example, a low-profile retail bank in a stable market may be able to operate very comfortably with a significantly lower common equity Tier 1 ratio than a high-profile universal bank with very public, high minimum capital requirements. assets) in order to avoid excessive dilution, equity credit may be reduced to 50% or even zero. Mandatorily Convertible Securities The following approach will be used for securities with mandatory conversion features that do not hinge on a trigger event; rather, they mandatorily convert to first loss capital at a predetermined date in the relatively near future. These are rare in the banking universe. In order to achieve 100% equity credit, all of the following features will be necessary: Subordination: The securities must be subordinated to all senior creditors. Full discretion to cancel coupons: See above. 3
Short period until conversion: The securities must convert to common equity or equivalent first loss capital within three years. Even then, a rating committee may elect not to assign equity credit if there are material concerns about the viability of the bank in the period before conversion. In such a case, equity credit will be capped at the level the security would achieve without the mandatory conversion feature. assets) in order to avoid excessive dilution, equity credit may be reduced to 50% or even zero. 50% Equity Credit Perpetual Instruments With Coupon Omission Features The following features will be necessary to achieve 50% equity credit: Subordination: The securities must be subordinated to all senior creditors and in most cases senior only to common equity or, for non-joint stock companies, the most comparable first loss capital. Permanence: The securities must be perpetual, with no step-ups or other incentives to redeem. They must have at least five years to the first call date at issue, and supervisory approval is required for any repayment of principal. Full discretion to cancel coupons: This means features such as look-back/dividend pusher clauses and parity securities language are likely to negate a security s ability to obtain equity credit. While contingent write-down or equity conversion is not a requirement for such securities to achieve equity credit, it will be a requirement for Basel III-compliant Tier 1 instruments from 2013. Dated Instruments Without Coupon Omission Features The following features will be necessary to achieve 50% equity credit: Subordination: The securities must be subordinated to all senior creditors. Maturity: The securities must have at least five years to maturity. Permanent and full write-down or conversion to first loss capital (in most instances common equity) well before a bank becomes non-viable: Again, the point at which a bank might be considered non-viable will be determined by a rating committee and is likely to vary by type of bank and by jurisdiction. assets) in order to avoid excessive dilution, equity credit may be eliminated. Mandatorily Convertible Securities The following features will be necessary to achieve 50% equity credit: a) Host instrument is a senior instrument or subordinated instrument without coupon deferral or omission features: Short period until conversion: The securities must convert to common equity or equivalent first loss capital within one year. Even then, a rating committee may elect not to assign equity credit if there are material concerns about the viability of the bank in the period before conversion. In such a case, no equity credit will be assigned. 4
assets) in order to avoid excessive dilution, equity credit may be eliminated. b) Host instrument is a subordinated instrument with coupon deferral or omission features: Subordination: The securities must be subordinated to all senior creditors. Full discretion to cancel or to defer coupons. Short period until conversion: The securities must convert to common equity or equivalent first loss capital within five years and the requirements for 100% equity credit for mandatory convertibles are not met. Even then, a rating committee may elect not to assign equity credit if there are material concerns about the viability of the bank in the period before conversion. assets) in order to avoid excessive dilution, equity credit may be eliminated. Figure 1 Hybrid Treatment as FEC a Illustrative Summary Hybrid type Perpetual instrument with coupon omission features Treatment in the FEC ratio 50% equity Mandatorily convertible (true) - Subordinated, conversion within 3 yrs, full discretion to cancel coupons 100% equity - Subordinated, conversion within 5 yrs, deferrable or full discretion to 50% equity cancel coupons, does not meet requirements for 100% - Senior or subordinated without coupon deferral; conversion within 1 yr 50% equity Optionally convertible hybrid As host instrument Contingent convertibles (CoCos) - High trigger b, no restrictions on coupon omission (eg, Basel 3 Tier 1 host 100% equity instrument, high trigger) - High trigger b, non-deferrable (eg, Basel 3 Tier 2 host instrument, high 50% equity trigger) - Low trigger b As host instrument Notes: This is an illustrative summary only based on typical or anticipated hybrid features see the criteria for further details. Hybrid or capital instruments not listed above would not typically be treated as equity as part of the FEC ratio a FEC is an ancillary capital ratio. FCC is the agency s primary capitalisation measure and excludes all hybrid securities b A high trigger for contingent conversion to equity (or principal writedown) implies a conversion or writedown well before a bank becomes non-viable. A low trigger implies a writedown or conversion to equity that may be close to the point of non-viability. Source: Fitch 5
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEB SITE AT WWW.FITCHRATINGS.COM. PUBLISHED RATINGS, CRITERIA, AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE, AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE CODE OF CONDUCT SECTION OF THIS SITE. Copyright 2012 by Fitch, Inc., Fitch Ratings Ltd. and its subsidiaries. One State Street Plaza, NY, NY 10004.Telephone: 1-800-753-4824, (212) 908-0500. Fax: (212) 480-4435. Reproduction or retransmission in whole or in part is prohibited except by permission. All rights reserved. In issuing and maintaining its ratings, Fitch relies on factual information it receives from issuers and underwriters and from other sources Fitch believes to be credible. Fitch conducts a reasonable investigation of the factual information relied upon by it in accordance with its ratings methodology, and obtains reasonable verification of that information from independent sources, to the extent such sources are available for a given security or in a given jurisdiction. The manner of Fitch s factual investigation and the scope of the third-party verification it obtains will vary depending on the nature of the rated security and its issuer, the requirements and practices in the jurisdiction in which the rated security is offered and sold and/or the issuer is located, the availability and nature of relevant public information, access to the management of the issuer and its advisers, the availability of pre-existing third-party verifications such as audit reports, agreed-upon procedures letters, appraisals, actuarial reports, engineering reports, legal opinions and other reports provided by third parties, the availability of independent and competent third-party verification sources with respect to the particular security or in the particular jurisdiction of the issuer, and a variety of other factors. Users of Fitch s ratings should understand that neither an enhanced factual investigation nor any third-party verification can ensure that all of the information Fitch relies on in connection with a rating will be accurate and complete. Ultimately, the issuer and its advisers are responsible for the accuracy of the information they provide to Fitch and to the market in offering documents and other reports. In issuing its ratings Fitch must rely on the work of experts, including independent auditors with respect to financial statements and attorneys with respect to legal and tax matters. Further, ratings are inherently forward-looking and embody assumptions and predictions about future events that by their nature cannot be verified as facts. As a result, despite any verification of current facts, ratings can be affected by future events or conditions that were not anticipated at the time a rating was issued or affirmed. The information in this report is provided as is without any representation or warranty of any kind. A Fitch rating is an opinion as to the creditworthiness of a security. This opinion is based on established criteria and methodologies that Fitch is continuously evaluating and updating. Therefore, ratings are the collective work product of Fitch and no individual, or group of individuals, is solely responsible for a rating. The rating does not address the risk of loss due to risks other than credit risk, unless such risk is specifically mentioned. Fitch is not engaged in the offer or sale of any security. All Fitch reports have shared authorship. Individuals identified in a Fitch report were involved in, but are not solely responsible for, the opinions stated therein. The individuals are named for contact purposes only. A report providing a Fitch rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents in connection with the sale of the securities. Ratings may be changed or withdrawn at anytime for any reason in the sole discretion of Fitch. Fitch does not provide investment advice of any sort. Ratings are not a recommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature or taxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from US$1,000 to US$750,000 (or the applicable currency equivalent) per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a single annual fee. Such fees are expected to vary from US$10,000 to US$1,500,000 (or the applicable currency equivalent). The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name as an expert in connection with any registration statement filed under the United States securities laws, the Financial Services and Markets Act of 2000 of the United Kingdom, or the securities laws of any particular jurisdiction. Due to the relative efficiency of electronic publishing and distribution, Fitch research may be available to electronic subscribers up to three days earlier than to print subscribers. 6