Subordinated Debt: In the Spotlight Again

Typically, we observe increased usage of subordinated debt at our bank holding companies (BHCs) every few years. Over the past several months, the COVID-19 pandemic has placed additional attention on the banking system. Potential exposure to COVID-impacted industries and the associated credit risk has made capital preservation a prudent consideration at some firms. Most Fifth District banking organizations entered the pandemic with strong capital buffers. Despite these strong buffers and the fact that a large majority of banks remained well capitalized as of June 2020, we have seen a few bank holding companies raise subordinated debt in an effort to strengthen existing capital at their subsidiary banks. Regardless of the rationale for issuing subordinated debt, such as downstreaming proceeds to a banking subsidiary as Tier 1 capital, funding acquisitions or refinancing existing debt, we thought some reminders were in order.

We first discussed the topic in the November 2016 issue of News Flash. What follows (with an update in the threshold to qualify as a Small BHC under the Small BHC Policy Statement) is a republishing of the original article, as the information remains relevant today. If you have questions about your organization’s usage — or planned usage — of subordinated debt, we invite you to reach out to your supervisory contact at this Reserve Bank.

Back in the Spotlight: Subordinated Debt: November 3, 2016

While issuing subordinated debt often benefits the subsidiary banks, BHCs should ensure that their subsidiary banks aren’t harmed by excessive parent debt that could require significant bank dividends to service those obligations.

BHCs as a source of strength

Keep in mind that BHCs are required to serve as a source of strength for their banking subsidiaries. Also, BHCs should factor the debt usage and appropriate limits into their capital plans. Here are some issues to consider when incurring this type of debt:

• Parent liquidity and the level of debt — Parent liquidity is assessed by looking at the contractual maturity of the BHC’s assets and liabilities to determine whether any funding gaps exist. We also focus on the debt-to-equity ratio and the double-leverage ratio, especially when the proceeds are downstreamed to the bank. The double-leverage ratio is calculated by dividing the parent’s equity investment in the subsidiary by its total equity, and a BHC is considered to have double-leverage when this ratio exceeds 100 percent. There is no specific limit for this ratio, but generally speaking, a double-leverage ratio above 120 percent is considered high and will get added scrutiny by the supervision team. The key factors we consider are how the ratios compare with the averages of peer institutions and the BHC’s ability to service and repay debt.

   

• Ability to service debt — Examiners will check to ensure that there’s adequate cash flow to make interest payments. When BHCs downstream proceeds to the bank, they typically hold back a year or two of interest payments or downstream all funds and rely entirely on dividends from the subsidiary to make future payments. To the extent that the BHC relies on dividends from the bank to service the debt, we’ll analyze the bank’s existing and projected earnings and capital positions. Overreliance on bank dividends may become a concern when the subsidiary’s capital position is weakened or its earnings power declines to the point where bank dividends are restricted by bank regulators. For additional information on parent only liquidity and cash flow, see section 4010.0 of the Bank Holding Company Supervision Manual.

   

• Tier 2 treatment — For BHCs not subject to the Small Bank Holding Company Policy Statement (generally those over $3 billion in assets), regulators look at capital on a consolidated basis. For these BHCs, subordinated debt may count as Tier 2 capital if certain criteria are met. For example, the instrument must be subordinated to depositors, unsecured and have an original maturity of at least five years. If you desire Tier 2 treatment for the debt, please see Section 217.20(d) of Regulation Q for a full description of the requirements. For smaller companies subject to the Small BHC Policy Statement, consolidated capital is not applicable and Tier 2 treatment isn’t formally analyzed from a supervisory standpoint. Nonetheless, examiners would still analyze the impact of the debt on the BHC. Also, bankers may want to ensure that newly incurred debt qualifies as Tier 2 capital in case BHC growth took it above the $3 billion threshold in the future.
  
  
• Reciprocal holdings — Bank holding companies that issue subordinated debt should be aware if they have reciprocal holdings with other subordinated debt issuers. Reciprocal debt holding could, in some instances, result in a deduction of those holdings from regulatory capital under section 217.22 (c) of Regulation Q.
  
  
• Enforcement actions — If a BHC is under an enforcement action, it will likely be required to obtain the prior written approval of both the Reserve Bank and applicable state regulator before incurring debt. You’ll also typically need prior regulatory approval for making interest payments on and redeeming debt. We’ll closely scrutinize these requests, so we should receive them at least 30 days in advance.