YES Bank AT1 bonds write-down exposes gaps in our ratings systems, yet again

Even as depositors of YES Bank heaved a sigh of relief after the RBI lifted the restrictions on withdrawals last week, investors in the bank’s additional Tier I bonds (AT1 bonds) have been left high and dry. As it stands, ₹8,415 crore of YES Bank’s AT1 bonds have been written down in full, implying that investors in these bonds are not getting their money back. While it is unfortunate that many retail investors have fallen prey to the gross mis-selling by bank officials and financial advisors and invested in these bonds, the savvier institutional investors can hardly plead ignorance. Basel III-compliant AT1 bonds have always been inherently risky because they come with a built-in ‘loss absorbency’ clause which means that in case of stress, banks can write off such instruments or convert them into equity. These conditions are clearly laid down by the RBI in its circular on ‘Implementation of Basel III Capital Regulations’.

Yet mutual funds and other institutional investors with exposure to YES Bank’s AT1 bonds have been up in arms. Did these investors draw relief from the fact that such loss-absorbency clause had never been triggered in India? Or that the RBI’s regulatory checks and timely intervention would avoid a situation wherein a bank becomes non-viable? Maybe. But importantly, the ratings assigned to these bonds, also appear to have given a false sense of comfort to investors. According to a recent BusinessLine analysis, of the 73 active Indian AT1 bonds issued by various banks, most are rated as AA+ or AA-, indicating high degree of safety regarding timely servicing of financial obligations. How do such rosy ratings reflect the underlying risk associated with such bonds? While Indian rating agencies mostly notch down the rating of these bonds by one or two levels from the bank’s overall corporate credit rating, global rating agencies notch down ratings on such bonds by at least four levels from a bank’s viability ratings. Most of the AT1 bonds issued by global banks are rated BBB(+/-) or BB(+/-).

This brings us to the festering issue of faulty credit assessments by rating agencies. The grave lapse in diligence in the IL&FS episode by rating agencies has cost the financial system dearly. The revelation by Grant Thornton of nexus between key employees of IL&FS group and rating agencies, only goes to show that there are deep-rooted issues in the functioning of rating agencies. There has been enough said on the conflicting business model of rating agencies, where the ‘issuer pays’ model often influences the assessment of the issuers’ credit rating. Alternate models where rating fees could be funded out of money raised from issue of bonds, should be explored by the regulator. But above all, the regulator will have to take rating agencies to task and impose strict penal action for their murky role in recent episodes. After all, repeated failure to fulfil their fiduciary obligations cannot be dismissed as a ‘one-off instance’ of error in judgment.

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