We are fast approaching the retirement of LIBOR. This may have implications for the equity content of certain hybrid capital instruments we assess.

Some market participants have asked us whether we would lower our assessment on the equity content of an outstanding hybrid capital instrument in a scenario where the scheduled retirement of LIBOR makes it likely the issuer will redeem a LIBOR-linked instrument on or before the call option date rather than introduce a robust fallback provision.

This article describes how we apply "Hybrid Capital: Methodology And Assumptions," published July 1, 2019 (hereafter, "Hybrid Criteria"), in these scenarios and includes quotations from that criteria.

Scenario In Question

This article addresses our analytical approach to a scenario where:

• A hybrid capital instrument currently pays a fixed rate coupon but is scheduled to switch to a LIBOR-based floating interest rate on a preset future date (hereafter, "switch date"),
• The switch date is after the scheduled cessation of the referred LIBOR,
• The instrument lacks a robust LIBOR fallback provision, leaving it unclear or controversial how to determine the interest rate that would apply after the switch date, and
• We come to expect the issuer will not introduce a robust fallback provision and instead will redeem the instrument on or before the switch date, typically by exercising its call option.

In this article, we describe whether such a scenario, in particular the expected early redemption, would negatively affect our assessment on any equity content of a hybrid capital instrument. Paragraph 10 of the Hybrid Criteria contains the following statement.

How We Assess Such A Scenario

Paragraph 28 of the Hybrid Criteria indicates the instrument must satisfy seven conditions to achieve intermediate equity content. The second condition indicates the instrument must satisfy the following.

Therefore, the key question here is whether the expected early redemption on or before the switch date creates what constitutes an "effective maturity" in paragraph 28.

"Effective maturity" is defined as follows in the glossary of the Hybrid Criteria.

When we expect the issuer will redeem a hybrid capital instrument on or before the switch date, we will determine whether this meets the conditions in the fifth bullet point of the "effective maturity" definition quoted above. Under this bullet point, a high likelihood of redemption would constitute an effective maturity only if we "consider replacement with an equal or higher equity content instrument unlikely." We will assess the likelihood of such a replacement based on various factors including, but not limited to, a public statement from the issuer, its interactive communication with us, and/or its past record of capital management. The timing of our assessment can differ depending on the specifics of the case and events. We may assess the likelihood of replacement before cessation of LIBOR if we have sufficient information to assess the likelihood at an early stage. In some other cases, we may have sufficient information to determine the likelihood only at a point further into the future, for example if the switch date is multiple years after LIBOR cessation.

For hybrid capital instruments that prudentially regulated banks and insurers issue, paragraph 19 of the Hybrid Criteria could also be relevant. Paragraph 19 includes the following statement.

Related to this, the Basel Committee on Banking Supervision provides that for an instrument issued by a bank in order for it to be included in Additional Tier 1 or Tier 2 capital, the bank must not do anything that creates an expectation that the call will be exercised ("https://www.bis.org/publ/bcbs189.pdf"). Therefore, when a bank decides not to introduce a robust LIBOR fallback provision to its hybrid capital instrument, our equity content assessment could be negatively affected if the relevant regulator considers such a bank's decision constitutes what the Basel Committee calls "anything which creates an expectation that the call will be exercised."

In summary, the high likelihood of a call on or before the switch date would negatively affect our equity content if:

• As per the definition of "effective maturity" in the Hybrid Criteria glossary, we "consider replacement with an equal or higher equity content instrument unlikely," or
• As per paragraph 19, for a hybrid capital instrument that a prudentially regulated bank or insurer has issued, "it is not included in regulatory capital."

Once A Hybrid Is Redeemed

If the issuer actually redeems a hybrid capital instrument on or before the switch date without a replacement, we will review our assessment on the equity content of the same issuer's remaining hybrid instruments by applying paragraph 14 of the Hybrid Criteria, as follows. The first bullet is elaborated by paragraphs 22-23 of "Guidance | General Criteria: Hybrid Capital: Methodology And Assumptions," published July 1, 2019.

When we apply paragraph 14 to redemption on or before the switch date, the reference to "Effective Maturity date" refers to the effective maturity date incorporated in our initial assessment of the hybrid instrument's equity content, not the switch date. This is because we are assessing whether the issuer redeems the instrument earlier than it originally intended. For example, if (1) a hybrid instrument is structured so that its coupon rate will switch from fixed to LIBOR-based floating in 2022, and (2) our initial equity content assessment recognized an effective maturity in 2037 (due to a legal maturity or a material step-up in 2037), and (3) subsequently we came to expect the issuer to call the hybrid in 2022 without replacement, (4) therefore we lowered our equity content assessment to no equity from intermediate in 2021 by recognizing a new effective maturity in 2022, and (5) the issuer actually calls the hybrid in 2022, then this falls into the situation where "the issuer redeems any part of a hybrid that we assessed as having intermediate or high equity content before its Effective Maturity date," as described in paragraph 14 of the Hybrid Criteria. This is because "Effective Maturity date" in the paragraph 14 still refers to 2037, not 2022, in this example.

LIBOR Cessation Is Not An External Event In Our View

According to paragraph 14 of the Hybrid Criteria, one of the conditions in which "we may keep intermediate or high equity content on the remaining outstanding hybrid issues and continue to assign equity content to future hybrid issuances" is when "the hybrid was redeemed due to an External Event." Therefore, whether we consider LIBOR cessation an external event is a relevant question when a hybrid is called without replacement on or before the switch date.

An external event is defined as follows in the glossary of the Hybrid Criteria.

In this context, we generally consider that discontinuation of LIBOR would not constitute an external event, because:

• Cessation of LIBOR has been expected for many years. Many currently outstanding hybrids were issued when the issuer should have been able to expect LIBOR cessation.
• The issuer would likely have been able to, and still be able to, introduce a robust fallback provision. Accordingly, any disruption due to LIBOR cessation would be different from a change in tax law, accounting, or regulation, which the issuer cannot address.

Related Criteria

• Hybrid Capital: Methodology And Assumptions, July 1, 2019

Related Publications

• Guidance: Hybrid Capital: Methodology And Assumptions, July 1, 2019