Asia’s Warning About Basel Bonds

Updated October 9, 2013, 3:38 p.m. ET

Asia’s Warning About Basel Bonds

A supposed crisis-prevention measure confuses investors.

Some people think a proliferation of novel, hard-to-value credit-linked securities that behaved unpredictably in a crunch contributed to the 2008 financial crisis. Silly them! The Basel committee of central bankers and regulators knows better, and has now decreed that more such securities are the way to avert another crisis. We’re joking, but the so-called Basel III capital standards for banks are all-too serious. And Asian banks are becoming guinea pigs in one of the bigger Basel III experiments.Asian banks are in the vanguard in issuing new bonds complying with Basel III capital standards. The cash raised from the bond sales is supposed to augment shareholder equity and safe assets on hand, and under the new Basel rules is supposed to create a buffer to reduce the need for taxpayer infusions if an institution fails.

These “Basel bonds,” also known as Basel III-compliant non-viability contingent capital securities, or CoCos, function as regular bonds in good times. But if a bank’s regulator determines the institution is no longer viable, Basel bonds will be the first claims to be wiped out or converted to equity before the bank goes into bankruptcy, is acquired by a rival or is otherwise wound down.

Asian regulators have been quicker than their peers to write Basel III standards into their banking regulations, and as a result Asian banks have been the first to issue the new bonds. The Hong Kong unit of Industrial & Commercial Bank of China earlier this month issued the first dollar-denominated Basel bond in Asia, to the tune of $500 million. Metropolitan Bank & Trust of the Philippines, or Metrobank, will soon follow. Only a few European banks have jumped in ahead of full implementation of Basel-based rules, while U.S. banks are biding their time until Washington decides whether to introduce regulation to implement Basel.

Yet Asia’s experience raises serious concerns about the new rules. Markets are having trouble correctly pricing this new hybrid debt instrument. A survey by Fitch last month of 72 investors at asset-management companies, insurers, sovereign wealth funds, banks and hedge funds found that 52% think the rates of return offered by Basel bonds don’t adequately compensate for the risks.

That helps explain why large portions of these bond issues, including half of the ICBC issue, have been bought by retail investors. At current prices, the Basel bonds offer only slightly higher interest rates than the normal debt issued by banks, so observers speculate that retail investors might misunderstand how the Basel bonds work. Or, ironically, investors assume governments will step in to bail out financial institutions before pulling the regulatory trigger that is supposed to wipe out Basel bondholders.

Whatever the reason, regulators are growing worried about an obvious mismatch between risk, price and retail-investor participation. Thailand has barred retail investors from buying Basel bond issues, and Philippine investors will have to sign a form saying they fully understand the risks.

The other major problem is that banks are issuing Basel bonds before regulators have clarified how they will define the “point of non-viability” at which bondholders are supposed to be wiped out. Not only are investors being asked to price totally new debt securities with unusual features, they are doing so absent crucial information.

Basel bonds are supposed to reduce the need for government bailouts, but investors might be onto something with their apparent belief that governments won’t be able to help themselves. Confronted with retail investors and pension funds facing big losses on risky bonds for which they overpaid, politicians will be hard-pressed not to step in.

Relying on innovations such as Basel bonds to eliminate moral hazard is folly if governments won’t allow financial institutions to fail in an orderly way. Absent such a credible existential threat to banks’ shareholders, creditors and managers, new requirements for capital cushions and the like only risk inflating a market for novel securities with poorly understood risks. Throw in easy money, and this looks a lot like the formula that failed in the last crisis, with taxpayers on the hook again.