You're listening to Strictly Business Podcast with Lindsay Williams. There have been substantial changes to the fixed income market structure with the introduction of a new class of unsecured debt instruments known as Financial Loss Absorbing Capacity or FLAC instruments. With me now, Lisa McLeod and Stefan Naidoo, both portfolio managers at 91 in Cape Town. Lisa, if I can start with you, it's very easy. What and why? What are flak instruments.
And why issue yet another new type of instrument into the market? Thanks, Lindsay. So, yes, substantial changes to our fixed income market, as you say. So, FLAC is a new class of debt issued by banks. It's, just to explain it, it's contractually senior to Tier 2 and 81 debt, but it is subordinated to the existing senior debt. Thank you. In the event of a bank failure, losses will be absorbed according to a hierarchy of claims.
So FLAC instruments will then only absorb losses after all the capital has been depleted and equity in 81 and tier 2 holders. But FLAC will absorb losses before the senior debt holders. As to the why, so why issue a new class of debt? And I think really, you know, if you look across the globe, the systemically important banks are often considered just far too big to fail because when they collapse, it typically triggers this widespread disruption in the financial system.
And if we look historically, the risk of contagion then often forces these governments to bail out these banks and they use typically taxpayers' money. So it creates a bit of a moral hazard, if you want to call it that. So banks may take excessive risks because they know that they will be rescued. So it's this issue that needs to be addressed and that's when FLAC instruments come in.
It's a financial tool or an instrument that ensures systemically important banks have sufficient loss absorbing capacity so that they can continue operating even during financial distress without the government having to step in. It's really a regulatory change that's taken place in many jurisdictions and South Africa is now following suit.
But I think maybe just importantly, you know, in terms of the benefits of a financial system that is required to issue FLAC, I think really it enhances the resilience of a financial system and banks as a whole. It allows banks to respond a lot more effectively in a crisis. It improves their balance sheets and I think it does encourage much more responsible risk-taking.
And then, of course, importantly, it reduces the need for governments to then you use taxpayer money to bail out these banks in a crisis. And I think what is important to note is that when we changed our regulatory framework, we actually saw that Moody's upgraded their long term deposit ratings of South African banks. So it's a positive change and it enhances financial systems, strengthens the banks and bank balance sheets. So it should be viewed in a positive light.
Stefan, if you don't mind, I'll stay with Lisa. Lisa, I have to ask you, how will fixed income funds across the industry be impacted? And of course, 91 as well. Sure. So if we look at total FLAC issuance, it's likely to be around 250 billion across the sort of six large banks. And it's going to be issued over a period of six years. Then if we look at what is the total vanillia senior bonds that's currently an issue, it's of a similar size. Actually, it's slightly smaller than that.
So we expect vanilla senior bonds to be completely replaced by FLAC over the next six years. So funds that currently invest in the senior bank bonds, it can be fixed or floating rate notes, will be forced to replace all their senior bond exposure with FLAC or a combination of FLAC and other instruments such as NCD. So it will be quite a big change in the market. And I think one important characteristic of FLAC is that these FLAC instruments have an expected maturity of longer than one year.
So traditional Cisco money market funds that have a maximum maturity of up to 13 months, those will not be impacted by the industry change. It's rather the enhanced cash funds and the higher risk fixed income funds that will be impacted. Stefan, thanks very much for your patience. How do these FLAC instruments differ to the existing senior debt currently being issued in the market? And also we've got to have a look at the risk as well. Is there a difference in the risk that one is exposed to?
Yeah, Lindsay, you know, the difference comes down to two key things, the first being contractual subordination and the second being explicit bail-in language. So FLAC sits just below senior debt in the creditor hierarchy from day one. So it's not a risk that only appears in a stress scenario. It's written into the contract. And unlike tier two and 81, which can be bailed in at the point of non-viability, FLAC can only be bailed in at the point of resolution.
which is a more severe outcome where the South African Reserve Bank is essentially initiating the wind-up of a bank. At that point, it's at the SARB's discretion and flak exposure could be converted to equity or written down entirely. We have the pleasure of having some recent history with African Bank. You know, when African Bank was placed into curatorship in 2014, senior creditors took a haircut despite not being contractually loss absorbing.
So the SARB split the bank into good bank and bad bank and senior bondholders received less than par. So I think what we can learn from this point in history is that Saab has quite broad powers to allocate losses across the creditor hierarchy and holding senior debt alone did not provide protection against all losses.
So all that's happening now is FLAC makes loss absorption explicit rather than implicit, which is quite an important distinction, but perhaps less of a leap from the current senior debt than it first appears. What about pricing? How will these instruments price in the market? Will you as a financial institution be paid for the additional risk and will the risk of your portfolios at 91 change in any way? Well, FLAC has priced about 10 basis points above Vanilla Senior in the market.
To put that into context, Tier 2, which is next down in the creditor hierarchy, sits roughly 40 basis points above Vanilla Senior. So FLAC has come in quite tight, much closer to Senior than Tier 2. and inside what most indicative research at the time had expected. And this has really been driven by very strong demand for the asset class and somewhat limited supply.
I guess the question investors need to ask themselves is, is 10 basis points enough as a compensation for an instrument that is now contractually loss-absorbing? And again, I think this is important to revert back to that African Bank episode. where senior creditors absorb losses that they didn't expect to. So, flak holders face that same risk, but it's now explicitly written into the terms.
The counter-argument to that is that the probability of resolution for the South African banks is generally quite low. Credit losses would need to be 7 to 14 times higher than historic levels to approach the trigger point for a resolution.
And I think this is why it's quite important to highlight the need for... for strong fundamental credit research, because it's pivotal to understand that you're still facing the same fundamental risk drivers of these banks, which is what are the capital buffers in place? What is the ability for these banks to organically generate capital that's in earnings and both in size and quality? What is the robustness of the balance sheet? What risk are these banks underwriting?
How well have they provided for credit losses? And what are the liquidity measures in place. So, you know, in our view, we are from a portfolio risk perspective. The practical point is that FLAC issuance is expected to cannibalize existing vanilla senior term issuance. And the volume that the major banks need to issue over the next six years exceeds the amount of senior debt maturing over the same period.
So banks would get zero capital benefit from issuing vanilla senior and would simply just stop issuing it. And this goes to Lisa's point that, you know, the longer end of the market, FLAC would progressively displace the vanilla senior bonds as a core building block for SAFIX income portfolios. We don't expect a material increase in portfolio risk. The likelihood of a bank defaulting has not changed with the introduction of FLAC.
What has changed is on the 10 from the outset, these instruments are now loss absorbing and we've recognized the shift in our internal ratings. notching FLAC down compared to vanilla senior. And practically, this means within our internal risk framework, we have tighter limits for FLAC exposures than vanilla senior. Lisa, can I end with you? From your comments at the beginning of this podcast, it seemed to me that you welcome at 91, the introduction of FLAC. Is that the case?
And is it also important because of what Stefan has said about the African Bank example, and also what you said about the international benchmark? So all together, It's a welcome change. Lindsay, yeah, it is a welcome change. I mean, it is a big change, but I think overall it will lead to a much more sort of resilient market. And I think it's a change that's happened globally. You know, if South Africa did not undergo that change, we would sort of stick out in the global environment.
So I think it is a welcome change. Maybe, Steph, you can add to that. I think what is nice is there is no more ambiguity. And what the regulator is trying to say is... you know the risk you're signing up for on day one. And this is the risk you can expect should there be a resolution. Lisa, Stefan, thank you very much for your time. Lisa McLeod and Stefan Naidoo are both portfolio managers at 91 in Cape Town.
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