The Yes Bank court ruling undermines the concept of loss-absorbing AT-1 bonds

In the wake of the Global Financial Crisis of 2007-09, the Bank for International Settlements and its Basel Committee for Banking Supervision recommended stiffer capital requirements and regular stress testing for banks. AT-1 bonds flow from the Committee’s so-called Basel III norms. AT-1 bonds are perpetual bonds issued by banks as a capital buffer to absorb the loss and sit alongside Common Equity in Tier 1 of a bank’s capital structure. These are issued with the explicit understanding that they could be written off if the bank ends up in a soup but remains a going concern and carries a higher-than-market coupon to reflect this element of risk.

Systemically important banks — very large banks whose collapse would affect not just their depositors, bondholders and investors but the financial system itself — are required to build higher loss-absorbing capital buffers in addition to AT-1.

In 2020, India’s banking regulator, the Reserve Bank of India, placed a moratorium on Yes Bank, removed its incumbent management and placed it under an administrator. The administrator decided to write off AT1 bonds. The bondholders were peeved, naturally, and challenged the decision. Their protest had no merit: after all, they knew the inherent, risky nature of the AT-1 bonds and were willing to accept that risk in return for the superior returns on offer. They challenged the write-off in the high court.

A high court division bench has upheld their challenge, not on merits, but on procedural grounds. The administrator informed the stock exchange of the decision to write off AT-1 bonds one day after a new scheme of reconstruction of the bank, complete with new management, had been notified. The high court ruled that the administrator ceased to have the power to write off the AT1 bonds after the scheme of reconstruction had been notified, and thus the writing off of the AT-1 bonds does not stand.

But two questions arise. One relates to the validity of the court’s procedural reasoning. Did the administrator lose his authority on the notification of the new management? Who was in charge between the notification of the new management and its taking charge? Was the bank supposed to be placed under a managerial vacuum, or was the administrator in charge till the new management took charge? Did the decision to write off the AT1 bonds come into force only on notification of stock exchanges?

The bigger question relates to the regulatory arrangement for the financial sector. If the banking regulator followed the regulatory procedure envisaged when the Basel Committee on Banking Supervision instituted the Basel III norms in its attempt to save a mismanaged bank from failing and infecting other transaction partners with its malady, should the court be holding up the process? An added wrinkle is that while the draft reconstruction scheme contained the measure of writing off AT1 bonds, the final reconstruction scheme did not contain it after the demand raised by AT1 bondholders that the bonds should be converted into equity instead of being written off.

RBI and its administrator do not emerge smelling of roses from such reported vacillation and omission. But that does not undermine the purpose of AT-1 bonds and the validity of writing off these bonds to absorb loss as a bank approaches insolvency. The matter would, it is to be hoped, be clarified when the high court decision is appealed in the Supreme Court.

The whole point of Kafka’s dark allegory is to bring out the alienating, disruptive effect of rules administered without concern for the purpose of framing the rules in the first place. Emerging India can ill-afford a precedent that undermines the concept of loss-absorbing AT-1 bonds.