Thread by @niravstoons

After the news of Yes Bank's AT1 Bonds going to zero a thread on Capital Structure of a Bank (any typical Bank)

cc @teasri @deepakshenoy @andymukherjee70 @IndradeepKhan @RajeevthePawar
(#FF all above handles for Indian Finance)

Any Bank is an extremely leveraged entity.
It has source of funds -> Equity Investment, and Debt (in simplest of cases from retail deposits)
Use of funds -> lends out to different borrowers.

Banks have 2 main functions
- Creating Credit (lending money)
- Creating Duration

Simplest Example
Bank A has $10 of Equity Capital (10 share holders of 1$ each)
Has $90 of Depositors (90 retail depositors depositing $1 each) and with this $100 it has made loans to 100 different customers of $1 each.

This bank seems very well diversified on both sides.

Bank borrows say at 4% and lends at 8%
The salary of its employees and cost of running the branch is $2.

Interest Income = $8
Interest Expense = $3.6 (4% of 90)
Other Expense = $2

PRofit to share holders = $2.4 (after any defaults)

this Bank does 2 things
- Creates Credit for 100 people who want to borrow, and use the money for profitable activity or consumption and can pay it off.
- Lend money for long duration (e.g. 5 year car loan, 20 year home loan, 30 year infrastructure loan, 1y personal loan)

Meanwhile at the same time, the depositors are ensured safety of the money as long as 12.4% of the assets dont go bad.

Thus Equity investors take risk of a few defaults but get higher return, and debt holders get fixed returns but lower risk.

Also - bank borrows short term, demand deposits, current accounts to short term fixed deposits and lends long term.

Due to not everyone withdrawing money at the same time, bank always has money lying around, and can lend to people for long tenors.

As finance gets more complicated and more leveraged - not all liabilitiies are equal.

First to be paid are Customer Deposits.
Then Senior Bonds (unsecured)
Then AT1 Bonds (special bonds created for capital buffer)
and last equity.

Similarly to protect the liabilities, banking regulators ensure

small % of bank deposits is Insurance (to ensure deposits till INR 50k in India)
4% of deposits as CRR (Cash Reserve Ratio) with RBI
18% SLR (statutory liquidity ratio) in liquid governemnt bonds.

This ensures when some one wants to withdraw part of the money there is enough to be paid back in short time, while keeping long term loans on.

On the liability side the AT1 bonds have become popular post financial crisis, which pay a high rate of interest (coupon) and are perpetual in tenor, subject to being called every 5years or so.
BUT in case of Bank being bailed out, they lose all the principal

E.g. Bank Deposits pay 4%, Fixed Deposits pays 5%
5y Senior Bonds of a Bank pay 7%
But the AT1 bonds pay 10%
The additional return is for the liquidity and tail risk the AT1 bond takes

On the Asset Side - Yes Bank kept giving loans to those who were being turned away by other banks. Thus its Asset Quality was so bad, it cant pay off everyone.

What RBI has done -> New Shares would be issued by Yes bank and bought by SBI lead consortium

Thus equity of existing holders is diluted.
It has wiped out the subordinated debt (AT1) and ensured that senior bond holders and depositors are paid in full.

This Bail-in has proved there is no free lunch.
AT1 debt was being paid higher coupon, but for this precise risk the investor was taking.

One may say - Equity holders should be diluted a lot more (since the firm is going concern hopefully makes good loans now and makes money)

Another option was converting AT1 holders to common equity at say 10-20 cents on the $ ... which they havent done.

Which makes AT1 (or similar Contingent Convertible CoCo) bonds very vulnerable

If one actually looks at the balance sheet - the current assets if liquidated would struggle to pay off its senior bonds and depositors too. But if the bank is a going concern, there is hope it will earn in future and make money

Meanwhile on the other hand - PSU banks, they have consistently made bad loans and repeated bailed out by the tax payer.

This leads to moral hazard of not caring about loan quality, and political issue of waiving off farm loans etc.

Result is
- Promoters like Rana Kapur who sold shares are out
- Equity holders getting diluted even more take bulk of the hit
- AT1 is professional bond investors - get wiped out
- Senior bond holders come out as winners
- Depositors get money back

while some did pay for consequences of bad decisions, the depositors and Senior Bond holders dont. This is the price of maintaining confidence in shaky indian banking system.

Another good thing is - these losses ensure people are careful where they invest ...

... and bank management and credit committee is careful who to lend to.

Banking is a negative skew business.
As shown earlier 2% defaults can wipe out profits, and 12% can wipe out share holders.

Indian Debt industry had horribly mispriced Credit Risk - be it IL&FS or Yes Bank.

This cleanup was needed, and leads to healthier outcome.
Some how turn around in culture of Public Sector and Cooperative Banks is needed - to have a healthy financial system

Lending to individuals and businesses who can use money to create more value than what they borrow, and repay it to lenders -> ensures that savers get a decent return.

Just as each borrower needs a lender, each lender needs a creditworthy borrower who can pay back with interest