Registered banks in New Zealand must hold a certain amount of ‘capital’ to make them less likely to go out of business. This is called regulatory capital, and banks offer financial products to raise this money.
These products are similar to bonds and shares and often have a scheduled payment to investors (which can be cancelled). But they also have some very different features to bonds and shares, which makes them riskier; they may not be suitable for many investors.
What products are regulatory capital?
Regulatory capital products are similar to bonds or shares in a bank, but have very different features that make them more complicated and risky.
They are often referred to as ‘additional tier 1 capital’ or ‘additional tier 2 capital’. The products usually have names like:
Perpetual preference shares (equity)
Capital notes or perpetual subordinated notes (debt)
What features the product has are important for the rights, interest, returns the investment may give you and the level of risk you are accepting.
Common features of regulatory capital
The bank may stop distributions, or reduce the amount they pay to investors, even if they’re still in business.
The shares or notes may not be redeemed (i.e. repaid) so you won’t get back the money you invested unless you sell it on a secondary market (like the NZX).
The bank can convert some types of the notes into shares in the bank (or their parent company). The value of those shares at the time they are converted may be a lot less than the amount you paid for the capital notes.
Where these features are included, they will be described in the product disclosure statement (PDS). These features are usually subject to complex tests and conditions that even experienced investors can find hard to evaluate.
Companies that are not banks also issue products called capital notes or preference shares. This is not bank regulatory capital. The products may have similar features and risks but are issued for a different purpose. Investors should read the PDS carefully.
Understanding the risks
Although they might be marketed by a well-known company as offering a high return rate, these investments are complex and risky.
Some features of regulatory capital products can be difficult to predict. You should think about whether the higher risks are worthwhile, and whether those risks fit your investment needs.
Things to look out for
Interest payments may be reduced or stopped
Regulatory capital products nearly always allow the bank to stop paying interest, or reduce the amount of interest they pay, under certain circumstances. Sometimes interest payments are completely the bank’s decision, even if their business is profitable.
It might be difficult to predict the circumstances in which a well-known bank chooses to stop paying interest on its regulatory capital products, but you shouldn’t assume this would never happen.
Redeeming is usually (but not always)the bank’s decision
Although regulatory capital products are long-term investments, sometimes of ‘perpetual’ duration, some investors may expect the bank to buy back or redeem the product after an initial period, often five years. Any buy-back is usually the bank’s decision, and usually needs to be approved by the Reserve Bank.
You shouldn’t assume that because the bank is a household name they will buy back or redeem the products after this initial period.
Regulatory capital products are deliberately designed with features that give banks flexibility over payments. Although it can be difficult to predict when a bank might use these features, you should be aware that they can be used when it’s in the bank’s interests to do so.
The market price can change quickly
Regulatory capital products are usually listed on the NZX, but this doesn’t necessarily mean you will be able to sell them quickly, or at all. The market price can change quickly.
For example, the value of the notes or shares may suddenly fall if the bank suspends or defers interest payments, if they don’t buy back the notes when the market expected them to, or if there is a material change in the company or product credit rating, or in market interest rates.
Regulatory capital products are designed to protect the bank
These products are designed to make banks less likely to become insolvent. Their terms are often controlled by the requirements of ‘prudential regulation’, which is regulated by the Reserve Bank of New Zealand to protect the stability of the financial system, rather than your specific investment.
The risk of loss to the bank is reduced by passing this risk on to investors who purchase their capital notes.
The same features that give banks flexibility to cancel or postpone their obligations create complex risks for investors.
How to reduce risk
Read the PDS carefully to understand the terms and conditions specific to the regulatory capital product you’re thinking of investing in, and consider seeking financial advice.
Common terms used in bank capital notes
This means wealth, in the form of money or assets, used to measure the bank’s financial strength.
This means that your investment may never be repaid because there is no set date the bank has to repay it on. There may be terms allowing the bank to repay early, but you shouldn’t assume this will happen.
No fixed maturity date
This means the product protects the bank, not you, from loss. You may lose some or all of your investment if the bank needs to use the loss-absorbing features of the product.
This means your investment is not secured (made safer) by a mortgage or security over an asset.
This means if the bank goes out of business, investors will get paid after other creditors (people or businesses owed money) if funds are available.
This means where interest is not paid, the bank doesn’t have to pay that interest at a later date.
This means your investment can change into equity. For example, it could start as a note that pays an interest rate, but then be converted into shares that may not pay any dividends.
This is an independent opinion of the capability and willingness of a business to repay its debts (in other words, its creditworthiness). Don’t confuse the credit rating for a bank with the credit rating for their capital notes. Capital notes will usually have a lower credit rating than the general credit rating of the bank, because of the product’s higher risk. No credit rating is ever a guarantee the financial product being offered is a safe investment.